The new Double Tax Treaty (DTT) between China and Germany has been signed on March 28, 2014. The new DTT will supersede the current Treaty of 1985. Following the completion of the ratification process, the earliest possible date of the new DTT entering into force should be 1 January 2015.
In the following, the major changes of the new DTT are highlighted:
I. Permanent establishments (PE)
The new DTT extends the period for constituting a PE for a building site, construction, assembly or installation project or supervisory activities connected therewith to twelve months instead of the current six month threshold.
As in the current Treaty, the new DTT contains a provision for service PEs. According to this rule, service activities may constitute a PE, even if no fixed place of business has been established. The threshold for establishing a PE by means of carrying out service activities will be 183 days (within a twelve months period) instead of the current six months.
The allocation of profit between parent company and its PE has to be done in accordance with the arm’s length principle as laid down in the 2008 OECD model convention. The authorized OECD approach treating a PE as a separate and independent entity for profit allocation purposes has not been implemented in the new DTT.
II. Dividend distributions
The following chart illustrates the changes concerning withholding tax (WHT) on dividends:
Under the new DTT, the reduced WHT rate of 5% will be available if the following requirements are met:
The reduced WHT is not applicable to partnerships (Personengesellschaften) or individual shareholders.
- The beneficial owner receiving the dividend is a corporation, and
- directly holds at least 25% of the share capital of the company distributing the dividends.
Due to these changes, a special purpose vehicle (“SPV”) situated in Hong Kong will no longer be necessary in order to minimize the overall WHT burden to 5% as illustrated in the below chart:
However, there may be other reasons for maintaining an SPV in Hong Kong like for example the flexibility of laws or the possibility of an “easy” exit which have to be considered in each individual case as well.
III. Interest and royalty payments
For interest and royalty payments, the DTT WHT rate will remain unchanged at 10%.
In case of license payments for the use of, or the right to use any industrial, commercial or scientific equipment, the tax base for WHT calculation purposes is reduced from 70% to 60% of the gross payments. Thus, the effective WHT rate is only 6% according to the new DTT instead of 7% pursuant to the current one.
For German tax residents, the reduction of the WHT rate in these cases does not lead to any tax advantage since the deemed tax credit of 15% is abolished in the new DTT without any transition period.
According to the current DTT, a German resident corporation is allowed to credit Chinese WHT on royalties and interest payments against the German corporate income tax on such payments on the basis of the DTT rate even though China’s national WHT rate is lower. Pursuant to the new DTT, only the actual WHT paid in China may be credited against German corporate income tax.
This change is illustrated below:
IV. Alienation of shares
In the event a company sells its shares in a subsidiary, the country where the seller resides generally has the right to tax the resulting capital gains. Under the current DTT, the resident country of the subsidiary is also allowed to tax such capital gains (without any exception).
According to the new DTT, such capital gains may only be taxed in the resident country of the subsidiary in the following cases.
- More than 50% of the value of the sold shares is derived from immovable property situated in the resident country of the subsidiary:
- the seller of the shares has directly or indirectly owned at least 25% of the shares in the corporation at any time during a twelve months period preceding the sale of the shares (subject to certain exceptions for publicly traded corporations):
V. 183 Days Rule
The 183 Days Rule protects individuals that are resident in one state (e. g. Germany) but work in the other state (e. g. China) and derive income from independent personal services or employment.
In case of income of an employee working in China but resident in Germany, China is only allowed to tax the income generated in China if the following requirements are met:
VI. Switch-over Clause
A switch-over clause has been introduced for business income and dividend income.
The switch-over clause is applicable if the Chinese PE or subsidiary of a German corporation does not generate active income in the meaning of the German Foreign Tax Act (AStG). In such case, double taxation shall be avoided by the credit method instead of the exemption method.
With regard to dividend income, the switch-over clause is only relevant in case the German company owns minority shares in a Chinese corporation of less than 10% (otherwise, the Chinese dividend distributions are 95% tax-exempt anyway).