SEISEI INSIGHTS — Cross-border Compliance
Why Treaty Shopping Gets Denied: The Limits of a Substance-Free Intermediary
2026-07-07
"I set up a company in Hong Kong specifically to apply the reduced treaty rate to dividends coming out of China." When it comes to dividend planning through an intermediary holding company, we field this kind of inquiry constantly. In most cases the Hong Kong company has no employees, no office, and no business beyond receiving the dividend. A vehicle placed in a treaty jurisdiction solely to capture a low rate is regarded as treaty shopping — an abuse of the treaty — and may be denied.
Three Gates Against Abuse
Someone who should not qualify for treaty benefits sets up a shell in a contracting state to enjoy a low rate. Jurisdictions guard against this through several mechanisms.
| Defensive mechanism | Summary | Where it sits |
|---|---|---|
| Beneficial owner test | Excludes mere conduit companies; grants treaty benefits only to the substantive beneficiary | In China, per the tax authority's criteria |
| Limitation on Benefits (LOB) | Grants benefits only to those meeting "qualified resident" requirements | Found in US-style treaties |
| Principal Purpose Test (PPT) | Denies benefits where obtaining them was one of the principal purposes | Based on the BEPS Multilateral Instrument (MLI) |
Under the beneficial owner test, a company that carries on no real business activity and passes most of a received dividend on to a third-country resident within a short period is readily treated as a conduit and denied benefits. The PPT is a mechanism introduced by the OECD's BEPS project; China has joined the BEPS Multilateral Instrument (MLI), and through it the PPT is built into most of the treaties China has concluded.
China's Domestic Law Also Has a General Anti-Avoidance Rule
Beyond the treaty-level defenses, Chinese domestic law contains a general anti-avoidance rule. Article 47 of the Enterprise Income Tax Law provides that where an enterprise reduces its taxable income through an arrangement lacking a reasonable commercial purpose, the tax authorities may make an adjustment by a reasonable method. Article 120 of the Implementing Regulations then defines "lacking a reasonable commercial purpose" as having the reduction, exemption, or deferral of tax as the principal purpose. An intermediary with thin substance can fall within the reach of this rule.
When There Is a Shell but No Substance
A common fact pattern runs roughly as follows. An enterprise sets up an SPV in a treaty jurisdiction, holds the shares of a mainland subsidiary through it, applies a reduced rate to dividends, and saves a substantial amount of tax each year. But on examination the tax authority finds that the intermediary has no employees and no real office, that its income comes almost entirely from the mainland subsidiary's dividends, and that most of the funds received flowed on to yet another jurisdiction.
In that situation the company is unlikely to be recognized as the beneficial owner and may face back taxes and late-payment charges. Going further, the tax authority may, on a substance-over-form basis, deny the tax effect of the entire arrangement.
Treat It as a Structure
Using an intermediary to make use of a treaty is not itself the problem. The problem is a shell without substance. If you intend to design around treaty benefits, three things to confirm:
- Does the intermediary have real people, premises, and business?
- Are funds received passed straight through to a third country?
- Can the principal purpose of establishing the company be explained by something other than reducing tax?
A shell without the substance of "people, business, and decision-making" will not survive an examination. A treaty can be used — but only where the intermediary genuinely has substance.
This article provides general information on tax systems and does not constitute individual tax consultation. Specific filings and computations are handled by licensed professionals in the relevant jurisdictions whom we introduce.