H-share companies and individual income taxAbolition of individual income tax exemption puts H-share companies in the spotlight. Jeremy Ngai, Danny Yiu and Raymond Chan explain

On 9 June 2011, a Chinese company with H-shares listed on the Hong Kong stock exchange made a public

announcement that it would temporarily with-hold 20 percent of individual income tax upon distributing the final dividends to its individual shareholders for the year ended 31 December 2010. If any shareholders were eligible for tax treatment provided in double tax arrange-ments upon approval by the relevant Chinese tax bureau, the company would refund the excess withheld tax to them. The announce-ment attracted the attention of the markets and put the abolition of the individual income tax exemption under Circular 45 (Guoshuifa [1993] No. 45) in the spotlight.

From exemption to collectionAccording to China’s domestic individual income tax law, dividend income and capital gains derived by non-resident individuals from overseas listed shares of Chinese tax-resident enterprises are considered income sourced from China and within the scope of individual income tax. However, non-resident individuals previously enjoyed specific exemptions under the following tax circulars:• Circular45exemptedincometax(indi-

vidual income tax and the former foreign enterprise income tax for corporate shareholders) on dividends and capital gains derived by non-resident individual investors from B-shares and overseas listed shares, such as H- and N- shares of Chinese tax-resident enterprises.

• Circular20(Caishuizi [1994] No. 20) ex-empted individual income tax on dividends derived by non-resident individual investors from a foreign-invested enterprise, which generally refers to a Chinese company with at least 25 percent equity ownership by foreign investors. It should be noted that some of the listed Chinese tax-resident enterprises are foreign-invested enterprises.

But the issuance of Public Notice [2011] No. 2 by the State Administration of Taxation

on 4 January 2011 has invalidated the entire Circular 45, including the individual income tax exemption on dividends.

In fact, the collection of withholding income tax on dividends began in 2008 after the new Corporate Income Tax Law came into effect. A 10 percent withholding income tax was imposed on the payment of dividends arising from post-2007 after-tax profits to foreign corporate shareholders, including those owned by non-resident individual shareholders but registered under the name of corporate nomi-nees or brokers.

To avoid income tax on dividends, some non-resident individual shareholders held their shares directly in their own name to qualify for the individual income tax exemption under Circular 45, instead of registering under the name of corporate nominees or brokers. However, with the abolition of individual income tax exemption under Circular 45, the domestic standard individual income tax rate is 20 percent.

Clarifications by relevant authoritiesWith the abolition of Circular 45, non-resi-dent individual shareholders who are Hong Kong tax residents and who receive divi-dends from mainland non-foreign-invested enterprises listed in Hong Kong are generally subject to a treaty rate of 10 percent (instead of the domestic standard individual income tax rate of 20 percent) under the Arrange-ment between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income. The company’s decision to withhold 20 percent individual income tax and refund the excess caught public attention because non-resident individual sharehold-ers may have to go through complicated application procedures to obtain the reduced rate under the treaty benefit.

The SAT issued Circular 348 (Guoshuihan [2011] No. 348) subsequent to the company’s

announcement. The main points of the circular are:• TheSATacknowledgesthatindividual

shareholders who are Hong Kong residents and who receive dividends from non-foreign-invested enterprises listed in Hong Kong shall generally be subject to a treaty rate of 10 percent under the China-Hong Kong taxation agreement.

• Thoseindividualshareholderswhoaretaxresidents of a country that has a 10 percent dividend treaty tax rate in its double taxa-tion agreement with China do not need to make specific applications for entitlement to the 10 percent treaty rate as would otherwise be required under Circular 124 (Guoshuifa [2009] No. 124).

• Forindividualshareholderswhoaretaxresidents of other countries which have entered into a double taxation agreement with China with an applicable treaty rate of higher or lower than 10 percent, the treaty rate in the relevant double taxation agree-ment should be followed.

The detailed procedures are set out in the table on the opposite page.

Circular 363 (Guoshuihan [2011] No. 363) updates the list of double taxation agreement countries with a treaty rate other than 10 percent as originally specified under Circular 348.

Before Circular 348 was issued, the Hong Kong Inland Revenue Department issued a press release dated 4 July 2011 which mentioned a reply from the SAT to the department. The reply was also attached in a letter recently issued by the Stock Exchange of Hong Kong Limited to mainland companies listed in Hong Kong. The content of the reply is in line with Circular 348.

How simplified is the procedure under Circular 348?The clarification under Circular 348 should reduce the administrative burden of both non-resident individual shareholders and the Chinese tax authorities in terms of the

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application procedures required in Circular 124. However, it appears that the burden of ascertaining whether the non-resident individual shareholders are eligible for the treaty rate falls on the payers of dividends as withholding agents (i.e. the mainland companies distributing the dividends).

A few H-share companies have announced that they will strictly follow the guidance under Circular 348 and withhold individual income tax at 10 percent for those eligible for the 10 percent treaty rate, and at the applicable rate for those not eligible. But it remains to be seen how the H-share companies, as the withholding agents, will be able to identify the tax residence of their non-resident individual shareholders and withhold the individual income tax at the appropriate rates.

Lack of clarity over listed foreign-invested enterprisesIt is worth noting that both the reply from the SAT to the Inland Revenue Department and Circular 348 only deal with dividends paid by listed non-foreign-invested enterprises. This may imply that non-resident individual shareholders are still exempt from individual income tax if the dividend paying company is an foreign-invested enterprise pursuant to Article 2(8) of Circular 20. Some H-share companies have announced themselves to be foreign-invested enterprises and thus will not withhold any individual income tax on the

dividend paid to their non-resident individual shareholders in accordance with Circular 348.

Nevertheless, what constitutes foreign equity ownership for the purpose of assessing the foreign-invested enterprise status of the company remains unclear, such as whether it includes only founder shares (i.e. the shares owned by the shareholders prior to the IPO) according to Circular 87 (Guoshuifa [1993] No. 87). The status of shares subscribed and owned by foreign investors after the IPO is also in doubt. Further clarification from the SAT will be required on how to assess the foreign-invested enterprise status for H-share companies.

It is not yet known whether the individual income tax exemption for foreign-invested enterprises under Circular 20 will prevail in the long run as non-resident corporate shareholders have been subject to withholding income tax for dividends paid by foreign-invested enterprises since 2008.

Tax treatment on gains on trading of H-sharesAll the above tax circulars are silent on the tax treatments on gains derived by non-PRC residents on the trading of H-shares. However, another implication of the abolition of Circular 45 is that non-resident individual shareholders are now technically exposed

to individual income tax on capital gains arising from the disposal of as H-, N-, S- and B-shares. Unlike the individual income tax withholding on dividends where the withholding amount is determinable and can easily be administered by the overseas listed companies, there has been no individual income tax collection on capital gains so far.

Non-resident individual shareholders may also be entitled to protection from capital gains tax according to the relevant double taxation agreements. If the Chinese tax authorities do indeed start to enforce individual income tax collection despite the difficulties, the practical approach towards a tax treaty claim under Cir-cular 348 might still be a good reference point.

ConclusionThe issuance of Circular 348 demonstrates the SAT’s practical approach towards the granting of treaty benefits. Assuming that non-resident individual shareholders of H-share companies are predominately Hong Kong tax residents, tax treaty benefit claims available under Circular 124 would not bring about additional individual income tax collection for China’s tax authorities when compared to upfront individual income tax withholding at 10 percent. It only results in an administrative burden for both Hong Kong resident individual shareholders and the Chinese authorities. Capital gains tax on the trading of A-, B- and overseas listed shares by non-PRC residents should be the next controversial topic addressed by the SAT.

Jeremy Ngai is a PwC China tax and business advisory partner, Danny Yiu is a PwC tax services partner and Raymond Chan is the firm’s senior manager, China tax and business advisory.

Applicable withholding tax rate Withholding tax proceduresIf the treaty rate under the double taxation agreement is lower than 10 percent.

The withholding agent can apply for treaty benefit on behalf of the individual shareholder and, upon approval by the tax authorities, the overpaid tax will be refunded via the withholding agent.

If the treaty rate under the double taxation agreement is higher than 10 percent, but lower than 20 percent.

The withholding agent shall withhold and settle the tax at the rate that is stipulated in the double taxation agreement and no application for treaty benefit is needed.

If the shareholder’s home country does not have a double taxation agreement with China, the applicable treaty rate is 20 percent.

The withholding agent shall withhold and settle the individual income tax at the rate of 20 percent.

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