Filing Mutual Agreement Requests under PRC Tax Treaties
Filing mutual agreement requests under PRC tax treaties requires submitting a dossier to the State Taxation Administration within three years of assessment.
Multilateral Instrument Principal Purpose Test
Meaning
International tax anti-avoidance standards under global treaties function as a subjective criterion to determine whether the main objective of an arrangement was to obtain tax benefits. The multilateral instrument principal purpose test is a key component of the Base Erosion and Profit Shifting project led by the OECD and adopted by China. It allows tax authorities to deny treaty benefits, such as reduced withholding taxes on dividends or royalties, if it is reasonable to conclude that obtaining that benefit was one of the principal purposes of the transaction.
This test moves away from purely mechanical rules and focuses on the underlying commercial substance of the entity claiming the benefits. It is designed to prevent treaty shopping, where a company sets up a shell entity in a favorable jurisdiction solely to take advantage of a specific tax treaty.
Subjective Assessment
Determination of the intent behind a corporate structure requires the tax bureau to examine all the facts and circumstances surrounding the setup. The multilateral instrument principal purpose test does not require the tax benefit to be the only purpose, but merely one of the primary drivers of the decision. In practice, the State Taxation Administration of China looks for evidence of genuine business activity, such as local employees, physical office space and local management control.
If an investment from a foreign company into a Chinese factory is routed through a third country holding company with no assets or operations, the test is likely to be triggered. The burden is on the taxpayer to demonstrate that the structure has a valid commercial rationale that justifies the tax outcome. This shift in the burden of proof makes it easier for authorities to challenge complex offshore structures.
Administrative Enforcement
Operational procedures for the application of this test involve a detailed audit of the beneficial ownership and the flow of funds between jurisdictions. The multilateral instrument principal purpose test is applied during the review of applications for treaty relief or during a subsequent tax investigation. Chinese tax officials have the power to request internal emails, board minutes and strategic plans to understand the motivations of the investors.
If the test is failed, the treaty benefit is canceled, and the taxpayer must pay the standard statutory tax rate plus interest and penalties. The local tax offices are increasingly using data from the automatic exchange of information to identify suspicious patterns in cross border payments. This international cooperation ensures that the test is applied consistently across different tax jurisdictions.
Statutory Application
Integration of this global standard into the Chinese legal framework is achieved through the ratification of the multilateral convention to implement tax treaty related measures. The multilateral instrument principal purpose test modifies existing bilateral tax treaties between China and its trading partners without the need for individual renegotiations. It sits alongside other domestic anti-avoidance rules, such as the general anti-avoidance rule found in the Enterprise Income Tax Law.
While the test provides broad powers to the government, it also includes a carve out for arrangements that are consistent with the object and purpose of the treaty. This means that if a tax benefit is an intended result of a policy to encourage foreign investment, it should not be denied under this test. However, the boundary between legitimate tax planning and abusive avoidance is often a point of significant debate during audits.