By Anthony Diosdi
The major purpose of an income tax treaty is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Because tax treaties often substantially modify U.S. and foreign tax consequences, the relevant treaty must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction. The U.S. currently has income tax treaties with approximately 58 countries. This article discusses the implications of the United States.-People’s Republic of China Income Tax Treaty.
There are several basic treaty provisions, such as permanent establishment provisions and reduced withholding tax rates, that are common to most of the income tax treaties to which the U.S. is a party. In many cases, these provisions are patterned after or similar to the United States Model Income Tax Convention, which reflects the traditional baseline negotiating position. However, each tax treaty is separately negotiated and therefore unique. As a consequence, to determine the impact of treaty provisions in any specific situation, the applicable treaty at issue must be analyzed. The United States-People’s Republic of China Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States-People’s Republic of China Income Tax Treaty and the implications to individuals attempting to make use of the treaty.
Definition of Resident
The tax exemptions and reductions that treaties provide are available only to a resident of one of the treaty countries. Taxpayers who qualify as residents of the U.S. and the People’s Republic of China, or both are eligible for the benefits of the United States-People’s Republic of China Income Tax Treaty. “Resident” is defined in Article 4 of the treaty as any person or entity that is liable for tax in a contracting state because of “domicile, residence, place of head office, place of incorporation or any other criterion of a similar nature.” This definition is not materially different from the U.S. Model Treaty. Under this definition, a resident does not include a person who is subject to tax in either the U.S. or the People’s Republic of China only with respect to income derived from sources in that country. In other words, a resident is someone who is in either the U.S. or the People’s Republic of China by virtue of a personal relationship, such as citizenship or residence, as opposed to taxation on the basis of the source of income. Whether a person is a resident of the U.S. or the People’s Republic of China is determined by reference to the internal tax laws of the specific country.
Because each country has its own unique definition of residency, an individual may qualify as a resident of both the United States and the People’s Republic of China. This may result in an individual paying taxes on the same source of income to both the U.S. and the People’s Republic of China. To resolve such problems, the United States has included tie-breaker provisions in many of its income tax treaties. The United States-People’s Republic of China Income Tax Treaty does not contain a typical tie-breaker provision. The treaty provides that the “competent authorities” should follow the U.N. Model Treaty tie-breaker rules to determine treatment of a dual-resident individual. See 1984 Protocol, note 7, at para 5. (Under the treaty the U.S. competent authority is the Secretary of the Treasury or his authorized representative). Under the United States-People’s Republic of China Income Tax Treaty, the individual taxpayer has the responsibility to determine if a dual residency tax problem exists and to bring the matter to the attention of the relevant competent authority. See 1984 Protocol, note 7, at para 5.
For dual resident corporate taxpayers, resolving this issue can be more difficult. This is because the U.S.-China tax treaty not only requires the affected taxpayer to bring the dual residency problem to the attention of the relevant competent authority, the treaty provides that the competent authorities must reach an agreement. See art. 4, para 3. If the competent authorities cannot reach an agreement, the entity is not treated as a resident of either contracting state. See art. 4, para 3. Consequently, whether a dual-resident corporate taxpayer can enjoy reduced withholding rates under the treaty depends on the competent authorities of each country reaching an agreement.
The treaty incorporates a rule providing that when a company is a resident of both the United States under the treaty and of a third country under a separate treaty with the People’s Republic of China, the company cannot be considered a resident of the United States for purposes of enjoying the benefits under the treaty. See Note 4, at art. 4, para 4. Rather, the agreement between the People’s Republic of China and the third country prevails.
Business Profits and Permanent Establishment
A central issue for any company exporting its goods or services is whether it is subject to taxation by the importing country. Most countries assert jurisdiction over all the income from sources within their borders, regardless of the citizenship or residence of the person receiving that income. Under a permanent establishment provision, the business profits of a resident of one treaty country are exempt from taxation by the other treaty country unless those profits are attributable to a permanent establishment located within the host country. A permanent establishment includes a fixed place of business, such as a place of management, a branch, an office, a factory or workshop. A permanent establishment also exists if employees or other dependent agents habitually exercise in the host country an authority to conclude sales contracts in the taxpayer’s name.
The United States-People’s Republic of Chinese Income Tax Treaty defines a permanent establishment as places of management, branch offices, factories, workshops, and places for the extraction of natural resources. See note 4, at art 5. The treaty specifically excludes certain activities from the definition of permanent establishment. Some of these activities are: maintaining a fixed place of business solely for storing or displaying goods, purchasing goods or collecting information for the enterprise, and carrying on preparatory or auxiliary services.
Personal Services Income
Treaty provisions covering personal services compensation are similar to the permanent establishment clauses covering business profits in that they create a higher threshold of activity for host country taxation. Generally, when an employee who is a resident of one treaty country derives income from services performed in the other treaty country, that income is usually taxable by the host country. However, the employee’s income is exempted from taxation by the host country if the following requirements are satisfied: 1) the employee is present in the host country for 183 days or less; 2) the employee’s compensation is paid by, or on behalf of, an employer which is not a resident of the host country; and 3) the compensation is not borne by a permanent establishment or a fixed base which the employer has in the host country.
Article 13 of the United States-People’s Republic of China Income Tax Treaty permits a contracting state to tax the income of a nonresident who provides “professional services” of an “independent character” only when that person is present for a period exceeding 183 days of the calendar year or has a fixed base regularly available to him in the nonresident country for the purposes of performing his services. See art. 13, para 1. Professional services include: Independent scientific, literary, artistic, educational, or teaching activities, physicians, lawyers, engineers, architects, dentists, and accountants. Under Article 14 of the treaty, the income earned by a nonresident employee may be taxed by the contracting state if the employee is present within the state for more than 183 days, he is employed by a resident employer, or his compensation was paid by a permanent establishment of the employer. The treaty provides special taxes and exemptions for directors’ fees, entertainers and athletes, pensions, government services, teachers and researchers, students, and trainees. Under the People’s Republic of China individual income tax law, compensation is exempt from tax if the foreign employees remain in the country fewer than ninety days. The treaty extends this period to 183 days.
Dividends, Interest, and Royalties
Like the United States, most foreign countries impose flat rate withholding taxes on dividends, interest, and royalty income derived by offshore investors from sources within the country’s borders. Tax treaties usually reduce these withholding taxes. Tax treaties usually reduce the withholding tax rate on dividends to 15% or less. The United States-People’s Republic of China Income Tax Treaty provides that tax on dividends shall not exceed 10 percent. However, dividends may be taxed by each country.
The term “dividends” as used in the treaty means from shares or other rights, not being debt-claims, participating in profits, as well as income from other corporate rights which is subjected to the same taxation treatment as income from shares by the taxation laws of the contracting state of which the company making the distribution is a resident.
Tax treaties also usually reduce the withholding tax rate on interest to 15% or less. Under the United States-People’s Republic of China Income Tax Treaty, interest arising in a contracting state and paid to a resident of the other contracting state may be taxed in that other contracting state. However, the tax so charged shall not exceed 10 percent of the gross amount of the interest.
Most tax treaties provide for lower withholding tax rates on royalties. Typically, the rate is 10%. The U.S.-China Tax Treaty withholding rate is also 10%. A royalty is any payment for the use of, or the right to use, the following:
1) Any copyright of literary, artistic, or scientific work (but not including motion pictures, or films or tapes used for television or radio broadcasting);
2) Any patent, trademark, design, model, plan, secret formula or process, or other like right or property;
3) Any patent, trademark, design, model, plan, secret formula or process, or other like right or property;
4) Any information concerning industrial, commercial, or scientific experience, or
5) Any gains derived from the disposition of any right or property described in 1) through 3), where the proceeds are contingent upon the future productivity, use, or disposition of that property.
Gains from the Disposition of Property
Under the U.S. Model Treaty, gains from the disposition of property, such as capital gains on the sale of stocks and securities, generally are taxable only by the country in which the seller resides. United States-People’s Republic of China Income Tax Treaty, provides that gains from the alienation of movable (personal) property forming part of the business assets of a permanent establishment which is an enterprise of a contracting state (i.e., the United States or People’s Republic of China) has in the other contracting state, or of movable (personal) property pertaining to a fixed base available to a resident of a contracting state in the other contracting state for the purpose of performing independent personal services, including such gains from the alienation of such permanent establishment or such a fixed base, may be taxed in that other contracting state. However, gains derived by a resident of a contracting state from the alienation of ships or aircraft operated in international traffic and of movable (personal) property pertaining to the operation of such ships or aircraft shall be taxable only in that contracting state.
Private Pensions and Annuities
Under the United States-People’s Republic of China Income Tax Treaty, pensions and other similar remuneration paid to a resident of a Contracting State in consideration of past employment shall be taxable only in the Contracting State. The term “pension and other similar remuneration,” as used in the treaty, means periodic payments. This provision of the treaty provides an excellent opportunity for a non-resident of the United States to utilize the United States-People’s Republic of China Income Tax Treaty to reduce or eliminate the U.S. tax consequences associated with an Individual Retirement Account (“IRA”) or 401(k) plan distribution. For example, let’s assume that Tom is a Chinese national that came to the U.S. on an E-3 Visa for a short-term assignment. While working in the U.S., Tom contributed money to an IRA. Tom has returned to China and would like to withdraw money from his U.S. based IRA. However, Tom is concerned about the U.S. 20% withholding tax and the 10% early withdrawal penalty.
Since Tom is a citizen of China, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the United States-People’s Republic of China Income Tax Treaty to avoid the 20% withholding tax and the early withdrawal penalty. This is because under Article 17, Paragraph 1, of the United States-People’s Republic of China Income Tax Treaty, “pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State.” The Technical Explanations to the treaty further explain that “paragraph 17 provides that pensions derived and beneficially owned by a resident of one of the Contracting States in consideration of past employment .shall be taxable only in the State [of residency].” This means that under the applicable provisions of the United States-People’s Republic of China Income Tax Treaty, the country of residence has the sole taxing rights over pension distributions.
The terms “pensions and other remuneration” is not defined in the United States-People’s Republic of China Income Tax Treaty. However, the OECD defines the word “pension” under the ordinary meaning of the word which covers periodic and non-periodic payments. The OECD also provides that a lump-sum payment in lieu of periodic pension payments that is made on or after cessation of employment may fall within the definition of Article 23. See OECD 2014 Commentary, Art 18. Thus, although Article 23 of the United States-People’s Republic of China Income Tax Treaty makes a reference to “periodic payments,” the word “periodic” does not preclude Tom from excluding a lump sum IRA distribution from U.S. federal income tax. Even though the OECD or Article 18 of the United States-People’s Republic of China Income Tax Treaty does not mention the term IRA, the IRS has clarified that IRAs can be defined as pensions for articles in U.S. income tax treaties. See PLR 200209026. Since Tom is a resident of China, he can utilize the United States-People’s Republic of China Income Tax Treaty to avoid U.S. federal tax on the distribution from his IRA.
Income from Real Property
Tax treaties typically do not provide tax exemptions or reductions for income from real property. Therefore, both the home and the host country maintain the right to tax real property income. This rule applies to rental income, as well as gains from the sale of real property. The United States-People’s Republic of China Income Tax Treaty is no different.
Disclosure of Treaty-Based Return Positions
Any taxpayer that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. See IRC Section 6114. A tax return position is considered to be in conflict with the Internal Revenue Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.
The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:
1. The name and employer identification number of both the recipient and payor of the income at issue;
2. The type of treaty benefited item and its amount;
3. The facts and an explanation supporting the return position taken;
4. The specific treaty provisions on which the taxpayer bases its claims;
5. The Internal Revenue Code provision exempted or reduced; and
6. An explanation of any applicable limitations on benefits provisions.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.