TREASURY DEPARTMENT TECHNICAL EXPLANATION OF THE AGREEMENT BETWEEN THE GOVERNMENT OF THE UNITED STATES OF AMERICA AND THE GOVERNMENT OF THE PEOPLE'S REPUBLIC OF CHINA FOR THE AVOIDANCE OF DOUBLE TAXATION AND THE PREVENTION OF TAX EVASION WITH RESPECT TO TAXES ON INCOME（一） 　　GENERAL EFFECTIVE DATE UNDER ARTICLE 27: 1 JANUARY 1987 　　The Agreement, an accompanying Protocol, and an exchange of letters were signed in Beijing on April 30, 1984. Hereafter, the term "Agreement" refers to the three documents. The term "Agreement" has the same meaning as "Treaty" or "Convention", and the Agreement is subject to the same ratification requirements and has the same force as a Convention or Treaty. 　　The Agreement is based on the model income tax conventions published by the Organization for Economic Cooperation and Development in 1977, the United Nations in 1980, and the U.S. Treasury Department in 1981. 　　This technical explanation is an official guide to the Agreement. It reflects policies behind particular provisions as well as understandings reached with respect to the interpretation and application of the Agreement. TABLE OF ARTICLES Article 1---------------------------------Persons Covered Article 2---------------------------------Taxes Covered Article 3---------------------------------Definitions Article 4---------------------------------Residence Article 5---------------------------------Permanent Establishment Article 6---------------------------------Income from Real Property Article 7---------------------------------Business Profits Article 8---------------------------------Related Enterprises Article 9---------------------------------Dividends Article 10--------------------------------Interest Article 11--------------------------------Royalties Article 12--------------------------------Gains Article 13--------------------------------Independent Personal Services Article 14--------------------------------Dependent Personal Services Article 15--------------------------------Directors' Fees Article 16--------------------------------Artistes and Athletes Article 17--------------------------------Pensions and Annuities Article 18--------------------------------Government Employees and Pensions Article 19--------------------------------Teachers, Professors and Researchers Article 20--------------------------------Students and Trainees Article 21--------------------------------Other Income Article 22--------------------------------Elimination of Double Taxation Article 23--------------------------------Nondiscrimination Article 24--------------------------------Mutual Agreement Article 25--------------------------------Exchange of Information Article 26--------------------------------Diplomats and Consular Officers Article 27--------------------------------Entry into Force Article 28--------------------------------Termination Protocol ---------------------------------of 30 April, 1984 Exchange of Letters--------------------of 30 April, 1984 ARTICLE 1 Persons Covered 　　This article states the general rule that persons affected by the Agreement are residents of the United States or China or of both countries. The term "resident" is defined in Article 4. Certain articles may also apply to nonresidents; see, for example, Article 23, which concerns nondiscrimination, and Article 25, concerning exchanges of information. Article 1 is supplemented by Articles 1 and 2 of the Protocol. 　　Article 1 of the Protocol provides that the Agreement does not restrict any benefits provided by the laws of either Contracting State or by any other agreement between the Contracting States. This rule reflects the principle that a double taxation agreement should not increase the overall tax burden which would result in the absence of the Agreement. For example, if the Agreement permits a Contracting State to tax an item of income which under the law of that State is exempt from tax, the statutory exemption applies. A U.S. taxpayer, however, may not make inconsistent choices between the rules of the Internal Revenue Code ("the Code") and the rules of the Agreement. Article 2 of the Protocol is a simplified version of the traditional "saving clause" which preserves the right of the United States to tax its citizens and residents under its domestic law. The rule is drafted unilaterally, as China does not tax on the basis of citizenship and does not consider such a provision necessary to preserve its taxation of, and implement the Agreement with respect to, Chinese residents. The reference to "citizens" of the United States is understood by the parties to include former citizens whose loss of citizenship had as one of its principal purposes the avoidance of U.S. tax. Such former citizens are taxable in accordance with section 877 of the Code. Certain benefits of the Agreement are available to U.S. residents, as defined in Article 4 of the Agreement. Those benefits are the right to a correlative adjustment of tax liability as provided in paragraph 2 of Article 8, the exemption from U.S. tax of Chinese social security benefits provided in paragraph 2 of Article 17, the provisions concerning government employees, teachers and students of Articles 18, 19 and 20, and the benefits of Articles 22, 23, 24 and 26 concerning, respectively, relief from double taxation, nondiscrimination, the mutual agreement procedure, and diplomats. Further, it is understood that the benefits of the provisions concerning relief from double taxation, nondiscrimination, and the mutual agreement procedure will also be available to nonresident U.S. citizens to the extent applicable under the specific terms of those articles. ARTICLE 2 Taxes Covered 　　Paragraph 1 of this article enumerates the existing taxes to which the Agreement applies in each Contracting State. In the United States, these are the Federal income taxes imposed by the Code. As explained in Article 3 of the Protocol, U.S. social security taxes are not covered by the Agreement. The personal holding company tax and the accumulated earnings tax are also not covered by the Agreement, except that they will not apply to a Chinese company which is wholly owned, directly or indirectly, by individual residents of China who are not U.S. citizens or by the Government of China or a wholly owned agency thereof. 　　The Chinese taxes covered by the Agreement are the individual income tax, the income tax concerning joint ventures with Chinese and foreign investment, the income tax concerning foreign enterprises, and the local income tax. 　　Paragraph 2 provides that the Agreement shall also apply to taxes imposed after the date of signature of the Agreement, provided that they are substantially similar to those enumerated in paragraph 1. The competent authorities agree to notify each other of substantial changes in their respective income tax laws. ARTICLE 3 Definitions 　　Article 3 defines some of the principal terms used throughout the Agreement. Unless the context otherwise requires, the terms defined in this article have a uniform meaning throughout the Agreement. A number of important terms are defined in other articles. For example, the term "resident of a Contracting State" is defined in Article 4, and the term "permanent establishment" is defined in Article 5. The terms "dividends," "interest," and "royalties" are defined in Articles 9, 10, and 11, respectively. 　　The geographical territory of the two Contracting States is defined to include their continental shelf areas to the extent consistent with international law and their respective domestic laws. Thus, for example, activities taking place on the seabed or subsoil beyond the territorial sea of the United States will be considered to take place within the United States for purposes of the Agreement, provided that the United States has jurisdiction over such areas in accordance with international law and U.S. domestic law. The United States will interpret this definition in accordance with section 638 of the Internal Revenue Code and the regulations thereunder. The "United States" does not include Puerto Rico, the Virgin Islands, Guam, or any U.S. territory or possession. The "People's Republic of China" does not include Hong Kong, as Chinese tax laws are not in effect there. Moreover, in accordance with the Agreement between the United Kingdom and China on the future of Hong Kong, the taxes imposed by the Hong Kong Special Administrative Region will continue to be independent of the tax laws of the Central People's Government, and therefore the Agreement will not apply to Hong Kong even after 1997. 　　The term "person" includes an individual, a company, a partnership, and any other body of persons. It also includes, as provided in Article 4 of the Protocol, an estate or a trust. The term "person" is important because the Agreement applies to "persons" who are residents of one or both Contracting States and residence in a State is defined in terms of "persons" meeting certain criteria. A "company" is any entity treated as a corporation for tax purposes. 　　The term "nationals" means individuals having the nationality of a Contracting State and　legal entities deriving their status as such from the law in force in a State. 　　The competent authority in the case of China is the Ministry of Finance or its authorized representative and in the case of the United States is the Secretary of the Treasury or his authorized representative. Paragraph 2 provides that, in the case of a term not defined in the Agreement, the domestic tax law of the State applying the Agreement shall control, unless the context requires a different interpretation or unless the competent authorities agree on a common meaning in accordance with paragraph 3 of Article 24 (concerning the mutual agreement procedure). The Agreement does not include a definition of the term "international traffic" because that definition, as well as the substantive rules concerning the taxation of international shipping and air transport income, is contained in the Agreement Between the Government of the United States of America and the Government of the People's Republic of China with Respect to Mutual Exemption From Taxation of Transportation Income of Shipping and Air Transport Enterprises, which was signed on March 5, 1982 and entered into force on September 23, 1983. ARTICLE 4 Residence 　　This article defines those persons who are residents of a Contracting State and thus entitled to the benefits of the Agreement. The definition begins with a person's liability to tax under domestic law. Paragraph 1 lists several criteria which may be used in domestic law to determine residence for tax purposes. Citizenship is not one of the criteria; thus a U.S. citizen resident in a third country is not treated as a U.S. resident for purposes of this Agreement. The reference to persons "liable to tax" is not meant to exclude organizations of either country which are tax-exempt under special provisions of its domestic law, such as charities. However, it would not include a person liable to tax only in respect of income from sources in the taxing country, such as a resident of a third country subject to tax in the United States or China only on a source basis. A U.S. partnership, estate or trust is a resident only to the extent that the income it derives is subject to tax either in the hands of the entity or of its partners or beneficiaries. 　　Paragraph 2 provides that, where an individual is considered to be a resident of both Contracting States under their respective domestic laws, the competent authorities shall consult together to determine of which State the individual shall be a resident for purposes of the Agreement. In making that determination, the competent authorities will be guided by the rules of paragraph 2 of Article 4 of the United Nation's Model Double Taxation Convention between Developed and Developing Countries. (See Article 5 of the Protocol.) Those rules are the same as the rules contained in the corresponding paragraph of the OECD and U.S. Models. The first test is where the individual has his permanent home. If he has a permanent home in both countries the second test is where his personal and economic ties are closer (center of vital interests). If that test is inconclusive, or if the individual does not have a permanent home in either State, the next test is his place of habitual abode. The fourth test is nationality. If the individual is a national of both States or of neither of them, the competent authorities are instructed to settle the issue so as to assign a single State of residence. Once established under this article, the residence of the individual remains the same for all purposes of the Agreement. 　　For U.S. tax purposes, a company is a resident of the United States if it is created or organized under the laws of a state or the District of Columbia. For Chinese tax purposes, a company is a resident of China if its place of management (head office) is in China. Under paragraph 3, where a company is a resident of both Contracting States under their respective domestic laws, the competent authorities will attempt to determine a single State of residence through consultations. However, it would not be the policy of the U.S. competent authority to agree to treat an entity incorporated in the United States as not a U.S. resident. If the competent authorities are unable to reach Agreement, the company will not be considered a resident of either State for purposes of enjoying benefits under the Agreement. Thus, for example, dividends paid to a resident of China by a dual resident company would be eligible for the reduced U.S. 　　withholding rate of 10 percent. However, if a dual resident corporation paid a dividend to a U.S. resident, the statutory U.S. tax would apply with respect to that dividend. Dividends, interest or royalties arising in either Contracting State and paid to a dual resident corporation are not entitled to the reduced rates provided for in the Agreement. 　　Paragraph 4 deals with a case where a company is a resident of the United States for purposes of the Agreement, but is also a resident of a third country under another tax treaty between China and the third country (e.g., a corporation created under U.S. law but having its head office in Japan). Instead, the Agreement between China and the third country will prevail, and the company will be considered a resident of the third country and not of the United States for purposes of this Agreement. Thus, the company will receive the benefits of the other Agreement between China and the third country. ARTICLE 5 Permanent Establishment 　　The rules for taxation by a Contracting State of business income derived by a resident of the other State utilize the concept of a "permanent establishment." This article illustrates that concept. 　　Paragraph 1 defines a permanent establishment in general terms as a fixed place of business through which the business of an enterprise is wholly or partly carried on. 　　Paragraph 2 contains an illustrative list of permanent establishments. These illustrations are the same as those in the U.S. Model. They are a place of management, a branch, an office, a factory, a workshop, and a place of extraction of natural resources, such as a mine, well, or quarry. Subparagraph 3(a) provides that a construction site, assembly or installation project, or supervisory activities in connection with such a site or project, constitutes a permanent establishment if the site, project, or activities continue for more than six months. In such a case, a permanent establishment exists from the first day when work physically begins within the territory of the other Contracting State, including preparatory work. Each site or project and each enterprise is considered separately. A series of contracts or projects which are interdependent both commercially and geographically are to be treated as a single project for the purpose of applying the six month test. For example, a "turn-key" project in which a facility is constructed and equipment installed in it would be a single project. However, it is possible that a project which constitutes a permanent establishment for the general contractor may not be a permanent establishment for a subcontractor if the latter performs services there for less than six months. 　　For example, a subcontractor could install equipment at one site for four months and provide　supervisory services at a separate site for an unrelated contractor for three months without itself having a permanent establishment. 　　Subparagraph 3(b) provides that an installation, drilling rig or ship used to explore for or exploit natural resources constitutes a permanent establishment if it continues for more than three months. A series of projects or contracts will be interpreted in the same manner as in the case of construction sites. 　　Subparagraph 3(c) provides that the furnishing of services by an enterprise through employees or other personnel will constitute a permanent establishment of the enterprise in that other State when the activities in the other Contracting State continue for more than six months within a twelve month period. 　　Paragraph 4 identifies activities which may be carried on in a Contracting State which will not constitute a permanent establishment even if conducted through a fixed place of business. The activities enumerated are the same as in the U.S. Model. The use of facilities solely to store, display, or deliver goods belonging to an enterprise does not constitute a permanent establishment. Nor does the maintenance of a stock of goods belonging to the enterprise solely for the purpose of storage, display, delivery, or processing by another enterprise. An enterprise may maintain a fixed place of business solely to purchase goods or collect information or to carry on any other preparatory or auxiliary activity for the enterprise without being considered to have a permanent establishment. Any combination of the enumerated activities also does not constitute a permanent establishment, subject to the condition that the combined activity is of a preparatory or auxiliary character for the enterprise. 　　Paragraphs 5 and 6 concern the use of agents. Under paragraph 5, which is the same as in the U.S. Model, a dependent agent who acts on behalf of an enterprise and habitually exercises an authority to conclude contracts in the name of that enterprise is deemed to be a permanent establishment of that enterprise (whether or not there is a fixed place of business) unless the activities of the agent are limited to activities which would not constitute a permanent establishment under paragraph 4 if carried on directly by the enterprise. Paragraph 6 provides that an enterprise will not be considered to have a permanent establishment in the other State merely because it uses in that other State the services of an independent agent acting in the ordinary course of his business. However, an agent will not be considered independent if he acts wholly or almost wholly on behalf of that enterprise and it is shown that the transactions between the agent and the enterprise were not at arm's length. 　　Paragraph 7 states that control of one company by another does not, in and of itself, constitute either company a permanent establishment of the other. The determination whether a subsidiary is a permanent establishment of its parent corporation or conversely, or whether two or more subsidiaries of the same corporation are permanent establishments of the parent or of each other is made by reference to the tests set out in paragraphs 1 through 6. ARTICLE 6 Income from Real Property 　　Paragraph 1 provides that income derived by a resident of a Contracting State from real property situated in the other Contracting State may be taxed in the State where the property is situated. The United States may also tax such income of its citizens and residents in accordance with paragraph 3 of Article 1 (General Scope) of the Protocol. 　　Paragraph 2 provides that "real property" is defined in accordance with the law of the Contracting State where the property is situated. It, in any case, includes property accessory to real property, such as livestock and equipment used in agriculture and forestry, and payments for the use of natural resource deposits. It does not include ships and aircraft. 　　Paragraph 3 elaborates that income from immovable property includes income from the direct use, letting, or use in any other form of such property. 　　Paragraph 4 further elaborates that real property of an enterprise and real property used for performing independent personal services are also covered by this article. ARTICLE 7 Business Profits 　　This article provides rules governing the taxation by a Contracting State of income from business activity carried on in that State by a resident of the other Contracting State. 　　Paragraph 1 provides that business profits of an enterprise of one Contracting State shall be taxable only in that State except to the extent that such profits are attributable to a permanent establishment through which the enterprise carries on business activities in the other Contracting State. 　　Paragraph 2 provides that the profits to be attributed to a permanent establishment are those which it might be expected to make if it were an independent enterprise engaged in similar activities under similar conditions and dealing at arm's length with the enterprise of which it is a permanent establishment and all other related persons. 　　Paragraph 3 provides that deductions shall be allowed for expenses incurred for the purposes of the permanent establishment, including a reasonable allocation of executive and administrative expenses, without regard to where such expenses are incurred. However, the profits of the permanent establishment are not to be reduced by deductions for interest or royalties paid to the head office other than as reimbursements of costs incurred. 　　Paragraph 4 provides that, where the tax law of a Contracting State uses a deemed profit basis to determine the net income of a specific industry, the provisions of paragraph 2 do not preclude the use of that method provided that the results are consistent with the principles of this article. For example, for administrative reasons, China deems the profit of foreign shipping, airline, and oil drilling companies attributable to their Chinese operations to be a percentage of their gross receipts from China. Currently, the taxable income in such cases is deemed to be 10 percent of the gross income and that amount is subject to tax at the ordinary rates unless exempt under another provision of the Agreement. Such an approach is acceptable as long as its results are consistent with arm's length principles. 　　Paragraph 5 states that the mere purchase by a permanent establishment of goods or merchandise for the enterprise shall not result in profits being attributed to the permanent establishment. 　　Paragraph 6 provides that, unless there is good and sufficient reason to the contrary, the same method of determining profits attributable to the permanent establishment shall be used each year. In the United States, such a change may be a change in accounting method requiring the approval of the Internal Revenue Service. 　　Paragraph 7 provides, that, where business profits include items of income dealt within other articles of the Agreement, the provisions of those other articles govern. For example, the taxation of dividends, interest, and royalties is controlled by Articles 9, 10, and 11, respectively; 　　however, the terms of those articles provide that where dividends, interest, or royalties derived by a resident of a Contracting State are effectively connected with (attributable to) a permanent establishment in the other State, the provisions of this article apply and the item of income is taxed as business profits.