Strengthening Tax Compliance of High Net Worth Individuals
On March 24, 2021, the General Office of the CPC Central Committee and the General Office of the PRC State Council jointly issued the Opinion to Further Reform the Tax Collection and Administration. Of particular note, the Opinion requires the Chinese tax authority to “strengthen tax services and supervision for high-income and high net worth individuals in accordance with the law.”
Specifically, the Opinion requires the Chinese tax authority to (i) strengthen the risk-prevention, control and supervision of tax evasion and avoidance, such as the concealment of income, inflation of costs, profit shifting, taking advantage of no/low tax jurisdictions/locations, dual contracts (also known as “yin-yang contracts”) and related party transactions; and (ii) improve the tax audit enforcement force by increasing the investment of human resources in tax risk management and assessment and big data application.
The Opinion is a clear signal that the Chinese tax authority will strengthen its tax enforcement to focus on high net worth individuals (HNWIs). With effect from January 1, 2019, the introduction of the general anti-avoidance rule under the individual income tax (IIT) regime provides the requisite legal basis for the Chinese tax authorities to initiate anti-tax avoidance actions against individuals.
Further, strengthened international cooperation in terms of information exchange and technology development provides the tax authority with greater visibility of individuals’ income. As of December 2020, China, as an information receiving jurisdiction, has activated exchange relationships for financial account information under the common reporting standard (CRS) with 100 jurisdictions. This covers almost all popular jurisdictions used by Chinese HNWIs, including Hong Kong, Singapore, Switzerland, British Virgin Islands, Cayman Islands, etc.
The receipt of CRS information will enable the Chinese tax authority to have access to information relating to Chinese HNWIs’ offshore financial assets.
On the other hand, whether the Chinese tax authority can make effective use of such information to enhance tax collection and enforcement against HNWIs on a wide basis largely depends on the tax authority’s ability to process and analyze the information, given the large volume of information received. In response to the Opinion, we expect that the Chinese tax authority will invest increasing resources to enhance its information processing and analytic technologies.
More generally, due to Covid-19 and the recent economic downturn, the Chinese tax authority is facing pressure to increase tax revenue. Against this background, the Chinese government is strengthening its tax collection efforts and increasing its scrutiny of HNWIs.
In summary, there is a clear trend of the Chinese tax authority becoming more active and aggressive in tax collection and enforcement actions against HNWIs. It is important for HNWIs and their advisers to monitor the implementation of the anti-avoidance provision of the PRC Individual Income Tax Law, review the sustainability of existing tax arrangements, identify potential tax risks in advance, and take necessary measures to address potential tax audit risks.
Two Cases Relating to Determination of PRC Tax Residency Status of Individuals
There have been two recent cases involving the determination of the PRC tax residency status of individuals. In Case 1 below, a PRC national holding a Hong Kong tax residency certificate was considered to be a PRC tax resident under the tie-breaker rule. The tie-breaker rule is included in double taxation agreements (DTAs) to address dual tax residency issues.
In the case where an individual constitutes a tax resident of both contracting jurisdictions, most of China’s DTAs provide that the individual’s tax residency should be determined based on the following factors in sequence: the permanent home (with reference to the center of vital interests), habitual abode, and nationality. If the individual’s tax residency cannot be determined based on the above factor(s), the competent tax authorities are to determine this issue by mutual agreement.
In Case 2 below, a foreign national was considered to be a PRC tax resident under the tie-breaker rule.
Case 1
The taxpayer (Mr. S) was a PRC national. In 2013, Mr. S signed an employment contract with a PRC company under which he would perform his duties within mainland China. In 2014, Mr. S was appointed as an executive director of the PRC company’s Hong Kong subsidiary, and thereafter performed his work in Hong Kong. Mr. S obtained a Hong Kong tax residency certificate issued by the Hong Kong Inland Revenue Department for the tax years of 2014 and 2015.
Mr. S initially paid PRC tax on his income from his work in Hong Kong for these tax years, but subsequently sought a refund by claiming that he had overpaid PRC tax because he had failed to claim the protection of the China–Hong Kong double tax arrangement.
The tax bureau identified the following facts:
- Mr. S had a Chinese permanent household registration;
- he had a permanent home in both Hong Kong and mainland China;
- most of his income was derived from his employment with the PRC company;
- the PRC company made social security contributions in China on his behalf, whereas the Hong Kong company did not pay social security contributions for him in Hong Kong; and
- most of Mr. S’s relatives were living in China and most of his family’s assets were located in China, despite the fact that Mr. S’s wife and daughter had obtained non-permanent Hong Kong residency status and the daughter was studying in Hong Kong.
Based on these facts, the tax bureau determined that Mr. S had his center of vital interests in mainland China, and thus should be considered a PRC tax resident under the tie-breaker rule.
Case 2
The taxpayer (Mr. A) was a foreign national who was employed as the general manager of a foreign-invested enterprise located in Xiamen. The tax bureau commenced a tax investigation into his affairs, during which Mr. A applied to the tax bureau for a PRC tax residency certificate.
While Mr. A had stayed in China for less than 183 days in each of the tax years concerned, the tax bureau considered Mr. A as a PRC domiciliary tax resident based on the following factors:
- Mr. A had been living in China since 2019 and expressed the intention of long-term residence in China;
- he owned a company in China and was responsible for the management of operation of the company;
- he had been duly filing tax returns and paying tax in China; and
- he had other investments in China.
Mr. A was a tax resident of the country of which he was a national. The tax bureau therefore considered the application of the tie-breaker rules under the applicable tax treaty:
- Mr. A did not own any real property in his country of nationality, but had rented a house for long-term residence in Xiamen. Accordingly, the tax bureau concluded that Mr. A had a permanent home in China.
- Mr. A only derived passive dividends income in his country of nationality; whereas he actively managed his Chinese company and derived active income in China. On this basis, the tax bureau considered that Mr. A had his center of vital interests in China.
Based on these facts, the tax bureau concluded that Mr. A was also a PRC tax resident for tax treaty purposes, and issued a PRC tax residency certificate to Mr. A. Meanwhile, the tax bureau required Mr. A to file and pay taxes in China with respect to his worldwide income, and collected 500,000 Chinese renminbi ($77,100) in tax as well as late payment surcharges from him.
Observations
On the one hand, it is not surprising that the tax bureau considered Mr. S a PRC tax resident in Case 1. In fact, it is fairly common for the Chinese tax bureau to consider a Chinese national with a permanent PRC household registration as a PRC tax resident, even though the person has obtained permanent residence (e.g., a U.S. green card) in a foreign jurisdiction or a foreign tax residency certificate. Chinese nationals who wish to surrender their PRC tax residency status should de-register their permanent Chinese household registrations for the sake of prudence.
On the other hand, it is not a common practice for the Chinese tax authority to treat foreign nationals working in China as PRC domiciliary tax residents and to levy tax on their worldwide income. In fact, the PRC Ministry of Finance (MOF) and the PRC State Taxation Administration (STA) made it clear in a Q&A dated April 12, 2019 that foreign nationals who live in China due to reasons such as study and work and who will return offshore once they cease studying or working should not be considered to be habitually residing in China, and thus should not be considered to be PRC tax residents even if they have bought a residence in China.
It is unclear from the news report whether the tax bureau in Case 2 initiated the tax residency assessment before Mr. A applied for the PRC tax residency certificate. We do not think this represents a general trend that the Chinese tax bureau would enforce the taxation of worldwide income against foreign nationals working/living in China. Nevertheless, it is prudent to closely monitor these tax enforcement activities.
Proposed Legislative Reform for Family Trusts
China’s HNWI population has significantly increased in the last decade, making family trusts an increasingly important tool for wealth management and succession planning. Based on data published by China Trust Registration Co., Ltd., in 2020, the volume of assets held under family trusts experienced an annual increase of 80.29%. As of June 2020, there were 9,049 onshore family trusts with total assets amounting to 186 billion renminbi.
Despite the increasing need for family trusts, in practice, China has not introduced specific legislation dealing with family trusts, even though the PRC Trust Law has been in place for more than 20 years. In September 2018, the Trust Supervision and Administrative Department of the China Banking and Insurance Regulatory Commission (CBIRC Trust Department) issued Xin Tuo Han [2018] No. 37 (Circular 37), which, for the first time, defines the meaning of “family trust” from a regulatory perspective.
Under Circular 37, a “family trust” is defined as a trust business where (i) a trust company accepts the entrustment of a single person or family to provide customized affairs management and financial services; (ii) the amount or value of the family trust property is at least 10 million renminbi; and (iii) the beneficiaries are family members, which could include the settlor provided that the settlor is not the only beneficiary.
No further rules dealing with family trusts have been issued since then.
Taxation of Trusts
In addition to the lack of specific legislation dealing with family trusts, another issue is that China does not have clear rules on the taxation of trusts, let alone family trusts. As a result, there is much uncertainty about the taxation of trusts. For example, it is not even clear whether an asset transfer from the settlor to the trustee upon the establishment of a trust would give rise to taxes.
These uncertainties create impediments to the use of family trusts in China. Many people (including industry practitioners, professionals and academics) have therefore been advocating the improvement of the family trust legislation.
In the recent annual session of the National People’s Congress (NPC) and the Chinese People’s Political Consultative Conference (CPPCC) in March 2021, several NPC and CPPCC representatives (including the Head of the CBIRC Trust Department, Lai Xiu Fu, and the former chairman of the China Securities Regulatory Commission (CSRC), Xiao Gang) proposed that the family trust legislation be reformed.
Their key proposals are as follows:
- Firstly, the trust law should be amended and practical interpretation guidance should be issued to refine the rules concerning the transfer of trust property, the duties of the trustee and beneficiaries’ rights.
- Secondly, the ownership of trust property should be clarified and a trust property registration system should be established, which will also serve as the foundation of the taxation regime for trusts.
- Thirdly, in response to the major difficulty of tax collection for family trusts, a comprehensive taxation regime for trusts should be developed to ascertain the tax treatment for the transfer and distribution of trust property, and for the set-up and termination of a family trust.
That said, the proposed reform to family trust legislation was not included in the NPC Standing Committee’s Legislative Plan for 2021. Nor are we aware of any official news indicating that the STA has any concrete plans for issuing rules on the taxation of trusts. Thus, we expect that PRC onshore family trusts will still need to live with the existing legislative and taxation uncertainties for now.
Greater Bay Area Wealth Management Connect
On May 6, 2021, the Guangzhou Branch and Shenzhen Central Sub-Branch of the People’s Bank of China (PBOC), the Guangdong Office and Shenzhen Office of CBIRC, and the Guangdong Office and Shenzhen Office of CSRC jointly issued a consultation draft of the Detailed Implementing Rules relating to Pilot Scheme of Cross-boundary Wealth Management Connect within the Greater Bay Area (Draft Implementing Rules) for public comment until May 21, 2021.
This is major progress from when the PBOC, CBIRC, CSRC, the PRC State Administration of Foreign Exchange, the Hong Kong Monetary Authority, the Hong Kong Securities and Features Commission and the Macau Monetary Authority signed their Memorandum of Understanding on Supervisory Cooperation under Cross-boundary Wealth Management Connect in February 2021.
Qualifications of Mainland Investors and Investment Quota
The Draft Implementation Rules specified a series of issues, including but not limited to the qualifications of the participating mainland investors, products and banks, the investment quota, and the relevant supervisory and management requirements.
- In order to be a qualified investor in the “Southbound Connect” scheme, a person must fulfill all the following conditions: (i) has full capacity for civil conduct; (ii) has a permanent household registration in any of the nine cities within the Great Bay Area, or has at least five years’ social security contribution records or IIT payment records in such cities; (iii) has more than two years’ investment experience; and (iv) the person’s family has at least 1 million renminbi in net financial assets or at least 2 million renminbi in gross financial assets at the end of each month in the three most recent months.
- Both the net accumulative total inbound fund flow for the “Northbound Connect” scheme and the net accumulative total outbound fund flow for the “Southbound Connect” scheme are tentatively capped at 150 billion renminbi, and the net fund flow for each investor under the “Northbound Connect” scheme and the “Southbound Connect” scheme is capped at 1 million renminbi.
Potential Tax Implications
It is expected that the Greater Bay Area Wealth Management Connect Scheme will become a reality soon. From a tax perspective, it would be relevant to consider the PRC IIT implications when a mainland investor derives capital gains or receives income distributions from Hong Kong products, and when a Hong Kong person derives capital gains or receives income distributions from a PRC product.
Currently, in a pure PRC domestic context, in accordance with Cai Shui Zi [1998] No. 55 and Cai Shui [2002] No. 128 jointly issued by the MOF and STA, an individual is generally exempt from IIT on capital gains and income distributions received from securities investment funds. However, when paying dividends or interest to a fund, the relevant payer is obliged to withhold 20% IIT from the payment to the fund. The rules on the taxation of other financial products offered by banks are less clear. As a matter of practice, banks generally choose not to withhold IIT and require the individual investor to pay the applicable IIT. Not surprisingly, individual investors rarely file IIT returns in such situations.
It is still unclear whether the STA will issue specific rules to govern the taxation of investors participating in the Greater Bay Area Wealth Management Connect Scheme. If no specific rules are issued, we expect that the tax rules and practices described above will apply.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Nancy Lai is a Partner and Tingting Guo is an Associate with Baker McKenzie, based in Shanghai.
The authors may be contacted at: nancy.lai@bakermckenzie.com; tingting.guo@bakermckenzie.com