Treaty shopping and auditor independence | China Accounting Blog | Paul Gillis

Treaty shopping and auditor independence

Overseas listed Chinese companies mostly use offshore listing vehicles to avoid Chinese restrictions on overseas listings. These offshore vehicles are typically incorporated in the Cayman Islands for its favorable tax regime and well-established corporate laws based on English law. Companies listed through reverse mergers often have U.S. corporations at the listing vehicle, which has the unfortunate side effect of bringing the Chinese company under the U.S. tax system.

Overseas listed Chinese companies typically operate in China through subsidiaries known as wholly foreign owned enterprises (WFOE). A WFOE is a corporation and is also the normative form of operation in China for multinational corporations. When a WFOE has profits that it wants to distribute to its parent company, it must pay over a dividend withholding tax of 10% of the proposed distribution before it will get permission to convert the RMB profits to foreign currency and distribute them to the offshore parent company. In the case of Cayman Island holding companies, there is no further tax in the Cayman Islands so the profits can then be distributed to public shareholders with no further tax. In the case of U.S. parent companies (as in reverse mergers or MNCs) the U.S. may take another cut, although this is so complex I will not go into it.

The 10% Chinese withholding tax on dividends is not high by international standards (the U.S. charges 30%), but no one likes to pay taxes. A time worn method to reduce withholding taxes is to take advantage of tax treaties. Countries often sign agreements with other countries to reduce withholding taxes to encourage investment. China has signed over 90 of these agreements. In my previous career I made a good living finding ways to route income around the world using favorable tax treaties. Some of these techniques had exotic names, like the Dutch Sandwich, and they have come under attack all over the world.

The agreement with the United States sets the maximum withholding rate on dividends at 10%, which benefits Chinese investors in U.S. companies who would otherwise pay 30% but is of no help to U.S. investors in China since them treaty rate of 10% rate is the same rate that China applies in absence of a treaty. Investors have focused on the treaty with Hong Kong. Although Hong Kong is not a country, for tax purposes it is treated by China like one so there is a double tax agreement between the mainland and Hong Kong, and it is a favorable one. The withholding tax rate on dividends is reduced to 5%.

Accountants and lawyers in China have had a robust business in the past few years inserting intermediary Hong Kong companies into the corporate structure between the Cayman Islands public company and the WFOE (or in the case of MNCs between the home country parent and the WFOE). The Hong Kong company receives the dividend from the WFOE, claiming the benefit of the treaty with Hong Kong to reduce the withholding tax to 5%. Hong Kong does not tax the dividend, nor does it impose a withholding tax on distribution to the Cayman Islands company.

The problem with this approach is that China has anti-treaty shopping rules. China says that if the Hong Kong company has no real substance, it is not eligible for treaty benefits. If the Hong Kong company has no business operations and simply receives the dividend and passes it on to the Cayman company the normal dividend withholding tax rate of 10% would apply. China has issued a couple of regulations that set forth a series of considerations as to whether a company claiming benefit of a tax treaty has enough substance to qualify.

On April 12, the State Administration of Taxation issued Circular 165 to provide guidance to regional tax bureaus in applying the treaty shopping rules. Deloitte’s excellent analysis of the circular indicates that the rules are "intended to catch companies whose only investment and business operations relates to the shares respect of which the dividends received”. The Circular points out that all relevant facts and circumstances are to be considered, and no single negative factor should by itself disqualify the company from treaty benefits.

In my opinion, few companies using a Hong Kong intermediary company will qualify for the lower tax rate. Under accounting rules, companies should be accruing withholding tax on all profits in China that are not considered to be indefinitely invested in China. From my reading of financial statements, few companies are accruing this tax at the likely 10% rate, and instead are using the treaty rate of 5%.

Auditors have a conflict of interest here. Setting up these treaty structures has been a profitable business for the firms. How can they now tell their clients that it is more likely than not that the structure does not actually work, and that they need to accrue withholding taxes at a higher rate? The audit partner may be concerned with this issue, but how can he demand the company accrue withholding taxes at the non-treaty rate when he has his tax partner who he uses as an expert to evaluate the issue advocating the client’s position? Audit committees should not permit audit firms to also provide tax services.

Copyright 2020 Paul L. Gillis all rights reserved