For foreign-law entity LPs in a Qualified Foreign Limited Partner (QFLP), should their income be taxed at 10% or 25%? If the foreign entity is a Hong Kong resident, can it enjoy the CEPA tax preferential treatment, and would the tax rate be reduced to 5% after the preferential treatment?
By Daisy Gu & Ryan Yan
Question:
For foreign-law entity LPs in a Qualified Foreign Limited Partner (QFLP), should their income be taxed at 10% or 25%? If the foreign entity is a Hong Kong resident, can it enjoy the CEPA tax preferential treatment, and would the tax rate be reduced to 5% after the preferential treatment?
Answer:
1.Tax Rate Applicability
Whether a 10% or 25% tax rate is applied depends on whether the foreign-law entity LP's investment in the QFLP in China constitutes a Permanent Establishment (PE) in China.
(1)Standards for Determining a Permanent Establishment (PE)
a)Fixed Place PE
According to the United Nations Model Double Taxation Convention Commentary, the OECD Model Tax Convention Commentary, and the notice issued by the State Taxation Administration (STA) regarding the interpretation of the Agreement between the People's Republic of China and the Republic of Singapore for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Guo Shui Fa [2010] No. 75), a fixed base or place of business established in China conducting business activities will be deemed a PE, unless the activities are preparatory or auxiliary in nature.
b)Agency PE
If an agent in China has the authority to frequently enter into contracts on behalf of a foreign enterprise, the agent will be regarded as an agency PE.
If an agent in China has the authority to frequently enter into contracts on behalf of a foreign enterprise, the agent will be regarded as an agency PE.
a)Fixed Place PE
Pursuant to Article 2, Paragraph 1 of the Partnership Enterprise Law of the People's Republic of China (2006 Revision), which provides that a partnership enterprise refers to a general partnership or a limited partnership established within China by natural persons, legal persons, or other organizations in accordance with this Law, a QFLP qualifies as a commercial entity lawfully established in China and possesses an independent legal status as such. Accordingly, when foreign investors invest in domestic companies, non-profit organizations, or partnerships, these entities, by virtue of their independent legal personality conferred by law, are generally not regarded as a natural extension of the foreign investor’s own functions or structure within China. Furthermore, given the passive nature of an LP, a QFLP is generally not classified as a fixed-place permanent establishment in China.
b)Agency PE
If the foreign LP does not have the authority to manage the partner affairs of a QFLP and cannot control the QFLP, or the General Partner (GP) conducts business on behalf of the LP in its name, then the QFLP or GP is generally not deemed to constitute an agency PE of the LP in China.
However, certain exceptions may apply. For instance, if under the partnership agreement or other arrangements, the LP holds a veto power over major matters such as the QFLP’s investment decisions, the disposal of its assets, or the use of its assets as collateral, or if the LP influences investment decisions through decision-making committees or joint committees, the tax authorities may consider the foreign LP to effectively control the domestic GP, thus establishing a PE in China.
(3)Application of Tax Rates
a)If a PE is established:
Generally, dividends received by a foreign LP from a resident enterprise through a QFLP may qualify for the dividend tax exemption under Article 26(3) of the Corporate Income Tax Law, subject to specific procedural requirements. However, capital gains from the transfer of equity are subject to a 25% corporate income tax rate in China.
b)If no PE is established:
Pursuant to Article 91, Paragraph 1 of the Implementing Regulations of the Corporate Income Tax Law of the People's Republic of China (2019 Amendment) [State Council Order No. 714], “income derived by a non-resident enterprise as specified in Article 27(5) of the Corporate Income Tax Law shall be subject to corporate income tax at a reduced rate of 10%.” Accordingly, a 10% withholding tax rate applies.
2.Preferential Tax Rate
To implement the avoidance of double taxation agreements signed by the People's Republic of China, the State Taxation Administration issued the Announcement of the State Taxation Administration on Issues Concerning the “Beneficial Owner” in Tax Treaties (STA Announcement No. 9, 2018), which clarifies that, regarding dividends, interest, and royalties, the "beneficial owner" is a person who has ownership and control over the income or the rights or property generating such income.
Further, the STA issued an interpretation of this announcement, including an example where a Hong Kong resident investor A invests in a mainland resident and receives dividends. In this case, A is considered the "beneficial owner" if A is the Hong Kong government, a company listed in Hong Kong, or an individual resident of Hong Kong. It is important to note that, according to Article 10 (Dividends) of the Mainland-Hong Kong Tax Arrangement, if the Hong Kong resident A is a company listed in Hong Kong holding more than 25% of the shares of the applicant, A can enjoy a reduced tax rate of 5%. If A is a Hong Kong individual resident, A may be eligible for the 10% preferential tax rate under the same provision.
As the "Closer Economic Partnership Arrangement" (CEPA) between the mainland and Hong Kong is a general framework agreement, whether the 5% preferential tax rate applies needs further analysis in combination with the Mainland-Hong Kong tax arrangement and the specific circumstances of the LP.
