Introduction
Under Guo Shui Fa (1996)(87), Guo Shui Han (2008)(952) and the revised Business Tax Law, China imposes a 4.25% outbound shiptax—consisting of 1.25% enterprise tax and 3% business tax—on foreign companies’ gross income from transporting goods and passengers out of China. Chinese ship agents are the withholding agents responsible for remitting the shiptax to Chinese tax authority. No tax is imposed on inbound transportation. In Guo Shui Ban Fa [2011] No. 34, the Chinese Tax Authority found that time-charter income does not fall within the scope of Article 8 of the Korea-China Tax Treaty, which exempts “profit from operation of ship.” Instead, time-charter income is leasing income, subject to 10% withholding tax.
Basic Facts
The case of a Korean shipping company, Guo Shui Ban Fa [2011] No. 34, involves a Korean shipowner chartered its vessels to a Chinese company for transporting goods from China to Korea for a certain period of time. The Korean company was responsible for supplying crews, vessel maintenance and other supplies, and the Chinese company made periodical payments in accordance with their charter agreement.
The Korean company appointed the Chinese company to apply an enterprise income tax exemption certificate for its time-charter income pursuant to Article 8 of the Korea-China Tax Treaty. In that regard, the Korean company provided the Tax Registration Certificate issued by the Korean Tax Authority and Registration Certificate of Ocean Transportation issued by the Korean Land and Ocean Ministry.
After reviewing these documents, the Chinese Tax Authority denied the exemption application because (1) the scope of business activities indicated in the Tax Registration Certificate does not include international transportation; it only includes ship leasing, and (2) the Registration Certificate of Ocean Transportation similarly indicated that the Korean company’s business is “ship leasing”, not international transportation. Based on the Chinese Tax Authority’s experience, the Registration Certificate of Ocean Transportation issued by the Korean Land and Ocean Ministry would normally include “international ocean transportation”. Thus, the Chinese Tax Authority concluded that the Korean Company was only permitted to engage in “ship leasing”, not international transportation. As a result, its income received from the Chinese company did not fall within the scope of Article 8 of the Korea-China Tax Treaty.
Article 8, Shipping and Air Transport
The relevant provision in Article 8 of the Korea-China Tax Treaty states as follows:
- Profits from the operation of ships or aircraft in international traffic shall be taxable only in the Contracting State in which the place of head office or effective management of the enterprise is situated.”
The Korean company argued that because its head office is in Korea, its time-charter hire income should only be taxed in Korea under Article 8 of the Korea-China treaty. However, the Chinese Tax Authority determined that the income is not “profit from the operation of ships …” Instead, the income is leasing income because the Korean company did not actively operate its vessels and did not actually transport goods or passengers. A passive income should be considered as royalty and is covered under Article 12 of the Korea-China Tax Treaty.
Article 12, Royalties
The relevant provision in Article 12 of the Korea-China Tax Treaty states as follows:
- Royalties 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 per cent of the gross amount of the royalties.
- The term “royalties” … means payments of any kind received as a consideration for … the use of, or the right to use, industrial, commercial or scientific equipment, or for information concerning industrial, commercial or scientific experience.”
Under Article 12 of the Korea China Treaty, royalty income arising from China but earned by Korean companies can be subject to up to 10% withholding tax. Under the Chinese Enterprise Income Tax Law, foreign companies without a business establishment in China would be subject to a 10% withholding tax for their royalty income received from a source within China. Thus, the Chinese Tax Authority applied a 10% withholding tax to the Korean company since the income in question was a royalty income sourced in China. Unfortunately, neither Article 8 nor Article 12 of the Korea-China Treaty could help the Korean company in this situation.
Commentary
China has entered into treaties and international transportation agreements with more than 80 countries, intended to exempt or reduce tax on “profit from operation of ships”. Many of the treaties adopt the same language as the one used in the Korea-China Tax Treaty. This is why the Chinese Tax Authority’s interpretation of Article 8 of the Korea-China Treaty impacts all foreign shipping companies interested in applying for tax exemptions. In Guo Shui Ban Fa [2011] No. 34, the Chinese Tax Authority interpreted “profit from operation of ships” to include only income from voyage hire, not time-charter or bareboat charter. Income from time-charter or bareboat charter is leasing income, potentially subject to a 10% withholding tax. In hindsight, the Korean company should go ahead and just pay the 4.25% Chinese shiptax instead of applying a tax exemption and later get caught with a much higher tax.
Of course, each treaty may have subtle differences from one another. In some Chinese treaties, Article 8 provisions may use different language from the Korea-China Treaty; some treaties may reduce or even exempt the 10% royalty withholding tax. So companies should carefully analyze the scope of applicable treaty provisions before claiming a treaty benefit.
Finally, it is worth noting that Chinese Tax Authority’s interpretation of Article 8 of the Korea-China Tax Treaty contradicts that of its Korean counterparty. In Korean National Tax Service Case 46017-497, 2000. 10. 24, the Korean Tax Authority treated time-charter income as “profits from the operation of ships” and accepted it as covered under Article 8 of the Korea-China Tax Treaty. So a Chinese shipowner’s time-charter income received from a Korean company is exempted under the Korea-China Tax Treaty. Different interpretations by the Chinese and Korean tax authorities regarding the scope of Article 8’s benefit not only create uncertainties for purposes of tax planning, but also undermine the reciprocal nature of a bilateral treaty agreement. Hopefully, under the mutual agreement procedures provided in the Korea-China Tax Treaty, the tax authorities in Korea and China will reach a consensus soon.
Unless otherwise indicated by Flott & Co. PC in writing, any US federal tax advice contained in this blog is not intended or written to be used, and cannot be used, for either (i) avoiding penalties under the US Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any matter addressed within. For further information regarding this notice, please see http://www.flottco.com/