The law firm examines developments as affect compliance, taxation and private client matters in China. Issues include how anti-money laundering laws are being enforced, and highlights the kind of problems wealth managers must be aware of.
The author of this guidance note is Amy Ling of Baker McKenzie; it is part of a series of such analyses by the law firm that have been shared with this news service. The editors are pleased to issue this content and invite readers to respond. As always, the usual editorial disclaimers apply. Email firstname.lastname@example.org and email@example.com.
1. Individual Income Tax Law update:
After our update in 2019 on China's amended Individual Income Tax Law ("IIT Law"), China issued multiple following-up rules to implement the amended IIT Law.
One of the most notable changes under the amended IIT Law was the introduction of specific anti-avoidance provisions which cover related party-transactions and controlled foreign corporations ("CFC"), and the general anti-avoidance rule ("GAAR"). However, only the consulting draft of the IIT Law Implementing Regulations provided some key definitions. These key definitions were excluded from the final IIT Law Implementing Regulations. At the time, we anticipated that China would issue additional regulations to define the key concepts and definitions in order to effectively implement the newly introduced anti-avoidance provisions. However, despite the fact that China has issued multiple rules to implement other aspects of the amended IIT Law, no additional rules have been issued to fill the gap on the anti-avoidance provisions. In practice, we have not observed any active enforcement of the anti-avoidance provisions against individuals over the past year.
Notwithstanding this, we expect China will use the anti-avoidance rules as a tool to encourage compliance and strengthen enforcement measures, so this will be an area to monitor both in terms of additional regulations and practical enforcement measures.
China also released new rules dealing with foreign-sourced income as part of the amended IIT Law regime. Whether an individual needs to pay individual income tax ("IIT") in China on foreign-sourced income depends on the individual's tax residency. Only resident individuals should pay IIT in China on both their foreign-sourced income and China-sourced income. Non-resident individuals only need to pay IIT on their China-sourced income.
Foreign-sourced income includes income defined in the IIT Law. One important change from the rules under the prior IIT Law regime is that, if an individual transfers shares of a foreign company and, at any time within 36 months before the transfer, more than 50 per cent of the foreign company's asset value came from real estate in China, the income from the share transfer is regarded as China-sourced income. This means that both residents and non-residents will be subject to IIT on the gains derived from the transfer of such shares.
2. China's first Civil Code:
On 28 May 2020, China passed its first Civil Code, which will come into effect from 1 January 2021. The Civil Code is a set of comprehensive rules dealing with civil affairs, which covers property rights, personal rights, contracts, marriage, family relationships, succession and torts. It is a consolidation of existing laws, but also includes revisions and additions to these existing laws. We anticipate that the Civil Code will have meaningful implications in the wealth management space in areas of property ownership, marriage, divorce and inheritance.
3. COVID-19-related tax rules:
In contrast to many other countries, China has not released any specific rules addressing the possible tax consequences for individuals arising from COVID-19-related travel restrictions, closed borders, etc.
China has also not issued any significant COVID-19-related tax incentives as compared with other countries. We set out below a brief summary of certain COVID-19-related tax incentives and policies.
For the 2020 calendar year, an individual's donations to help prevent COVID-19 are fully deductible when calculating IIT. To enjoy this incentive, the individual can donate materials and cash through public welfare social organisations or governments, or directly donate materials to hospitals undertaking COVID-19 prevention and control tasks.
Deferral of tax filings
The PRC tax authorities have been extending tax-filing deadlines on a monthly basis depending on the situation and development of COVID-19 with extensions already provided for the monthly filings in February, March, April and May 2020.
4. FATF peer review of anti-money laundering
On 17 April 2019, the Financial Action Task Force ("FATF") released the "Anti-Money Laundering and Anti-Terrorism Financing Mutual Evaluation Report for China" ("Report"). The Report did not identify China as a country having strategic anti-money laundering deficiencies. According to the Report, China has undertaken a number of initiatives since 2002 that have contributed positively to its understanding of money laundering risks, and has established a multi-level national money laundering risk assessment system and formulated and implemented a national anti-money laundering strategic policy. Positive progress has been made in the anti-money laundering supervision of the financial industry, and financial institutions and non-bank payment institutions have a full understanding of their anti-money laundering obligations.
The report also pointed out that China's anti-money laundering work has some problems and provided recommendations. For example, the FATF recommended that the People's Bank of China should introduce an effective system of supervising and monitoring designated non-financial businesses and professions for compliance of anti-money laundering obligations. In response to this, China plans to revise its Anti-Money Laundering Law accordingly.
Another important recommendation noted in the Report is that China should ensure that competent authorities can obtain adequate, accurate and current "beneficial owner" information in a timely manner. This requires China to clarify the meaning of "beneficial owner" in the field of anti-money laundering and to formulate a "beneficial owner" registration system or management method.
5. Treaty tie-breaker case:
When determining whether an individual is subject to personal income taxes in a jurisdiction, generally it is relevant to first determine where the individual is a tax resident. Whether an individual is tax resident in China will determine whether the individual is taxable in China, how to calculate the taxable amount, and whether the individual can enjoy the benefit of preferential tax policies.
In practice, individuals may have connections with more than one jurisdiction, due to work, family or other economic connections, leading to dual tax residencies. In such a case, a tax treaty (if one applies) will be crucial in determining the individual's tax residency, in order to mitigate double taxation.
We summarise below a treaty case that illustrates how residency can be determined under the tie-breaker rules.
In 2013, Mr S signed a labour contract with Company C in Mainland China, and the contract stipulated that his main place of work was in the Mainland. Since 2014, Mr S also served as a director of Company C's Hong Kong subsidiary, Company D, and performed his duties in Hong Kong. Mr S obtained a Hong Kong resident identity card from the Hong Kong authorities in 2014 and accordingly was treated as a Hong Kong tax resident in 2014 and 2015. Based on this, Mr S believed that he qualified for tax treaty benefits under the Mainland China/Hong Kong double tax arrangement, and applied for a tax refund in Mainland China for overpayment of taxes.
In this case, the PRC tax authority took two steps to analyse Mr S's tax residency. First, the tax authority determined whether Mr S was a Mainland tax resident under domestic law. Since Mr S was a tax resident of both the Mainland and Hong Kong, the tax authority proceeded to determine Mr S's tax residency according to the "tie-breaker rule" in the double tax arrangement.
Tax residency in the Mainland based on domestic
The Mainland applies two criteria for the determination of Mr S' residence: the domiciliary standard and the physical presence standard. As long as either standard is met, an individual is a tax resident in the Mainland. Having a domicile in China refers to "habitual residence in China due to household registration, family, and economic interests". In practice, the tax authorities mainly judge whether there is a domicile based on household registration. Mr S has a domicile in the Mainland and was assigned by Company C to work and live in Hong Kong. When the assignment is over, he will return to live in the Mainland. Based on these facts, the tax authority determined that Mr S was a tax resident in the Mainland.
Tax residency in the Mainland based on the "tie-breaker
In most tax treaties and similar arrangements, such as the China / Hong Kong double tax arrangement, the tie-breaker rule uses a process of examining the taxpayer's ties with each jurisdiction concerned to determine tax residency. Because Mr S was a dual tax resident of both the Mainland and Hong Kong, the tax authorities used the "tie-breaker rule" to determine his tax residency status.
According to Notice 75 (1), permanent residence includes any form of residence - such as a house, apartment or room - rented by an individual on a long-term basis, not for temporary stays for certain reasons (such as tourism, business trips, etc.). Mr S owned three apartments in the Mainland and lived in one while he was in the Mainland. He also rented a residence in Hong Kong and lived there while working in Hong Kong, Mr S therefore had permanent residences in both Hong Kong and the Mainland. The next step is to determine which jurisdiction is his centre of his vital interests.
Centre of vital interests
According to Notice 75, to determine the centre of Mr S's vital interests, comprehensive judgments will be made with reference to factors such as family and social relations, occupation, politics, culture and other activities, place of business, and location of properties under management.
Among factors indicating Mr S's centre of vital interest, Mr S's wife and daughter acquired Hong Kong resident status and lived in Hong Kong. This suggested that his centre of vital interests was Hong Kong.
However, because his spouse was a housewife, and their daughter was studying in middle school in Hong Kong, it is likely that the family moved to Hong Kong to live together due to Mr S's work-related transfer. All other factors, such as Mr S's primary source of income, social insurance, relatives, main property and physical presence, suggested that his centre of vital interests was in the Mainland.
Therefore, according to the analysis required by Notice 75, the Mainland was the centre of Mr S's vital interests, and he should therefore be treated as a Mainland tax resident. Since Mr S was a tax resident in the Mainland, he could not qualify for treaty relief as a Hong Kong resident under the double tax arrangement. The tax authority therefore rejected his tax refund application.
As an individual with dual residence, Mr S should pay IIT on all income derived from the Mainland and Hong Kong. Although he paid IIT in Hong Kong on his income, such income is also taxable in the Mainland. Mr S could claim a foreign tax credit for the salaries tax paid in Hong Kong. This case effectively demonstrates how a dual tax residency status plays out under the tie-breaker rules.
6. Automatic exchange of CRS information:
As of May 2020, the Common Reporting Standard Multilateral Competent Authority Agreement has over 100 participating jurisdictions. China, as an information-receiving jurisdiction, has activated exchange relationships with 97 jurisdictions, which include most jurisdictions frequently used by Chinese residents for wealth management purposes, such as Hong Kong, Singapore, Switzerland, the British Virgin Islands and the Cayman Islands. The automatic exchange network will enable the Chinese tax authorities to have a better view of a Chinese tax resident's offshore assets and income.
1 Circular on Issuing the Agreement between the Government of the People's Republic of China and the Government of the Republic of Singapore for the Avoidance of Double Taxation and the Prevention of Tax Evasion with Respect to Taxes on Income and Interpretations on the Clauses of the Protocols thereof, Guoshuifa  No. 75, dated 26 July 2010 and effective from the same date ("Notice 75").