New Double Taxation Treaty between China and Germany signed
After several rounds of negotiations, on 28 March 2014, a new Double Taxation Treaty (“new DTT”) was signed between the governments of the PRC and Germany to replace the old DTT which was signed by both governments on 10 June 1985. The new DTT incorporates new elements of a typical modern double taxation treaty and has made several important changes to the old one. The new DTT will come into force on the 30th day after both countries have gone through their respective domestic ratification procedures and have notified each other, which may still take some time.
We highlight below the most important changes in the DTT for your reference:
1. Tax Resident Status
When determining the residence of a non-individual tax payer (e.g. a company tax payer), the criteria of “place of head office” is replaced by the criteria of “place of incorporation and place of effective management”.
2. Permanent Establishment (“PE”)
- a) Building site / installation PE
For “construction site, construction, assembly and connected supervisory activities”, the duration threshold to constitute a PE of such type has been extended from the previous 6 months to 12 months.
- Service PE
The duration threshold (regarding on-shore activities) for a Service PE has been changed from “6 months within any 12 months’ period” to “183 days within any 12 months’ period”. Due to lack of clear guidance from the PRC State Administration (“SAT”), tax authorities in China adopt a very strict practice when counting the “6 months” for Service PE purposes. I.e. for DTT purposes, the “6 months” may be counted on a calendar month basis. If there are personnel in China implementing a service project during a calendar month, that month may be counted as one month even if the presence in China lasts for only one day during the month. Therefore, the change from “6 months” to “183 days” in the future in many cases makes it less likely for a German enterprise to have a Service PE in China.
- Agency PE
Under the both the old and new Sino-German DTT, same as under other DTTs concluded by China, if an agent is empowered and regularly represents a German enterprise to conclude sales contracts in China in the name of that enterprise, the enterprise shall be regarded as having an Agency PE in China. However, if the agent is of an independent status, no Agency PE shall be constituted. The new DTT added some stipulations regarding the independent agent status. I.e. the independent agent status shall be denied, if the agent’s activities are devoted wholly or almost wholly on behalf of the enterprise from the other country and the commercial and financial conditions between such agent and the enterprise are not made on an arm’s length principle.
3. Shipping and Air Transport
The new DTT added a subsection under the item Shipping and Air Transport to define the scope of the profits derived from Shipping and Air Transport.
4. Associated Enterprises
The “Associated Enterprises” clause aims to address transfer pricing (“TP”) issues. I.e. adjustment of taxable profits made by one contracting country for TP reasons shall be allowed. The new DTT states that, in such case, the other country shall make an appropriate tax adjustment in the opposite direction.
Under the old DTT, dividend income can be taxed at the source country and the tax charged by the source country shall not exceed 10% of the gross dividend. The new DTT lowered the tax rate to 5% where the beneficiary owner of the dividends (being a company tax resident) directly holds 25% or more shares in the dividend-paying company. Otherwise, the tax rate shall still be 10%. It needs to be noted that the 5% tax rate does not apply to a partnership or a similar entity even though it may hold more than 25% capital in the dividend-paying company.
The new DTT also addresses the issue of dividend income paid out by an investment instrument (e.g. real estate investment trusts) where the profits (out of which dividends are paid) are derived from real estates. Under certain circumstances, the beneficiary owner of the dividends may not be protected by the 10% or 5% tax rate for dividends received from the investment instrument.
Same as under the old DTT, the rate for income tax imposed on interest income by the source company is limited at 10%. The taxation right is waived by the source country for interest (1) paid to the other government, (2) paid for loans guaranteed or secured by the government of the other state or any financial institutions wholly owned by the other state, (3) certain financial institutions specifically listed in the DTT.
The new DTT added a subsection under this clause which stipulates that the source country does not have the taxation right over the interest income for deferred payment related to purchase of commercial and scientific equipments.
The tax levied by the source country for royalties is still limited to 10% of the gross amount. However, for rentals of equipments, the effective tax rate is reduced from 7% to 6%.
8. Capital Gains
Under the old DTT, capital gains derived from transfer of shares can be taxed by the source country. The new DTT provides different rules as follows:
If the gains are derived from transfer of shares/rights of an entity, whose assets are mainly (above 50%) immovable properties, the gains can be taxed by the country where the immovable properties are located.
For transfer of shares other than the above, the source country has the taxation right over the capital gains, if the relevant share-holding (direct or indirect) ratio is 25% or above 25% (within the 12 months period prior to the share transfer). I.e. in such case, tax can be levied by the country of which the transferred company is a tax resident. An exception is made to gains from transfer of shares listed in a recognized stock exchange, where the source country shall waive the taxation right if the shares transferred by a resident of the other state accumulatively during a tax year are less than 3% of the circulated shares of the listed company.
9. Independent Personal Services
Under the old DTT, the source country has the taxation right over independent service income, if the services are conducted via a fixed base located in that country or the individual stays in that country for more than 183 days during the relevant calendar year.
The new DTT changes the 183 days rule to “183 days in any 12 months’ period commencing or ending in the relevant fiscal year”. Within such stipulation, if a German individual resident provides independent personal services in China (without a fixed base) and stays for more than 183 days in China during the 12 months’ period, e.g. from 1 July Year 1 to 30 June Year 2, he may be taxed in China for his independent personal service income attributable to his work in China for all months of Year 1 and Year 2, even though he may not exceed 183 days respectively in Year 1 and Year 2 on a calendar year basis.
10. Employment Income
The new DTT also modifies the 183 days rule in a similar way as in the independent personal service clause. I.e. for a German individual, in order not to be taxed in China for his employment income, he must not stay in China for more than 183 days “within any 12 months period commencing or ending in the relevant fiscal year”. Under the old DTT, he only needs to avoid staying in China for more than 183 days within the relevant calendar year. Of course, to avoid being taxed in China, he must also meet the other two conditions provided in the DTT, i.e. his employment is not paid or borne by a Chinese resident and is not borne by a PE or fixed base maintained by his employer in China.
Companies which dispatch their German resident employees to work in China shall pay close attention to this change when considering the PRC individual income tax implications of such employees.
11. Other Income
Under the old DTT, the source country generally has the taxation right over “other income” generated from that country. The new DTT changed the general rule so that “other income” shall only be taxed at the home-country (of which the person receiving such income is a resident). However, exception is made where “other income” is earned via a PE or fixed base located in the source country. In such case, the “other income” shall be taxed as the PE’s profits.
12. Method of Eliminating Double Taxation
Under the old DTT, where a PRC resident company receives dividend income from a German resident company, when calculating the tax credit amount, the corresponding German tax paid by the dividend-paying German company shall also be counted, provided that the PRC company holds 10% or more shares in the German company. The new DTT has changed the shareholding ratio requirement to 20%. This change is made in line with the PRC Corporate Income Tax Law (effective from 1 January 2008) which also requires 20% shareholding ratio for such tax credit purpose.
On the German side, there is one important change in the method of eliminating double taxation. I.e. the concept of “virtual tax credit” for dividends, interest and royalty income received from China has been eliminated in the new DTT. E.g. under the old DTT, for tax credit purposes, Chinese tax levied on a German company for PRC-sourced interest and royalties is virtually regarded as 15% of the royalties, even though the Chinese tax actually levied may only be less. Such mechanism no longer exists in the new DTT, i.e. only the Chinese tax actually paid can be counted when determining tax credit in Germany. The effect of such change needs to be assessed taking into consideration German domestic tax law.
Compared with the old DTT, the new one has a more complex mechanism in respect of methods of eliminating double taxation on the German side.
13. Miscellaneous Rule (anti-treaty shopping clause)
The new DTT added a separate clause as Article 29 to deal with treaty-shopping conduct, i.e. any tax benefits under the DTT shall not be available if certain transactions or arrangements were mainly aimed to secure a more favorable tax position and obtaining such more favorable tax treatment in these circumstances would be contrary to the object and purpose of the relevant clauses of the DTT.
14. Exchange of Information, Assistance in Tax-Collecting and Procedural Rules for Taxation at Source
There are some changes in the information exchange clause, e.g. the information that can be requested from the taxation authority of the other country is not subject to the limitation of Article 2 (Taxes Covered).
The tax-collecting assistance clause is newly added. The competent taxation authorities of both countries shall further discuss on detailed procedures to implement this clause.
Further a new clause was added as Article 28 regarding “Procedural Rules for Taxation at Source”.
15. Entry into Force
The new DTT will enter into force on the 30th day after both countries have informed each other (through diplomatic channels) of the completion of their respective ratification procedures.
It may be possible to plan in advance to benefit from the change in the DTT. E.g. dividend distribution may be delayed to the future so that 5% withholding tax under the new DTT may apply. However, it is advisable that such planning is assisted by tax professionals to avoid or reduce the risks of being challenged by tax authorities.