Residence-based taxation gains weight under new China–Italy double taxation treaty

By way of Law No. 182 of November 18 2024, published in Official Gazette No. 283 of December 3 2024, the Italian Parliament has ratified the new agreement for the avoidance of double taxation between Italy and the People’s Republic of China (the New Treaty), signed on March 23 2019. Once in force and effective, on January 1 2026, the New Treaty will replace the current double taxation treaty of 1986 (the 1986 Treaty).

Even though China is not an OECD member, it has been a key partner since 2007. Compared with the 1986 Treaty, the New Treaty is therefore more aligned with the latest version of the OECD Model Tax Convention on Income and on Capital (the OECD Model), which means the residence of the taxpayer will acquire more weight when both the contracting states claim taxing rights over the same item of income. There remain, however, some provisions still inspired by the United Nations Model Tax Convention (such as the so-called service permanent establishment) that will favour the retention of taxing rights to the host country of investment (the source principle).

The New Treaty does not fall between the covered tax agreements of the Multilateral Instrument (MLI) signed by Italy and China on June 6 2017. Therefore, its provisions will not automatically be changed to match the MLI provisions when Italy ratifies the MLI. This is not a serious issue, since the New Treaty implements the minimum standards to prevent the abuse of tax treaties provided by the OECD MLI through the provision of a statement in the preamble of the convention and of a principal purpose test (Article 24).

The New Treaty includes the Italian regional tax on productive activities (IRAP) among the Italian covered taxes. This update should make it possible to deduct from IRAP any excess of Chinese taxes not creditable against the Italian corporate income tax (see Italian Supreme Court decision No. 21047/2023).

The New Treaty changes the approach to solving issues of dual residence of legal entities: while the 1986 Treaty provided a tie-breaker rule based on the place of effective management (POEM), the New Treaty, consistently with the latest version of the OECD Model, entrusts the solution to a mutual agreement procedure among the authorities of the contracting states, with the POEM only one of the possible factors considered to define a link with one territory or another.

Ironically, this change arrives shortly after Italy has amended its domestic rules on the definition of the residence of legal entities, adopting the POEM as one of the linking rules with the objective of alignment with international tax treaties.

As clarified by the technical report to the ratification bill, the changes related to taxation of cross-border dividends, interest, royalties, and capital gains are expected to have the greatest impact for taxpayers since they tend to broaden the limits on the taxing rights of the source country.

The New Treaty reduces the withholding tax rate applicable to dividends to 5% from 10% if the beneficial owner is a company that holds directly at least 25% of the capital of the company paying the dividends throughout a 365-day period that includes the dividend payment days.

In this context, the new wording of Article 23 denies the creditability of taxes paid in China against Italian taxes to the extent that the underlying income is subject to a substitute tax or to a final withholding tax in Italy, even if by operation of law. This implies that Italian individuals would no longer be entitled to claim the creditability of Chinese withholding taxes against the Italian 26% substitute tax due on dividends since, according to the principles upheld by the Italian Supreme Court (decisions No. 25698/2022 and 10204/2024), such a remedy is excluded if the applicable treaty expressly provides that the credit is not recognised if the income is subject to a compulsory substitute/withholding tax.

The New Treaty confirms that the taxation of interest in the source state cannot exceed 10%. However, if the interest is paid to a financial institution on a loan with a duration of at least three years for the financing of “investment projects”, the withholding tax cannot exceed 8%.

The New Treaty reaffirms the tax exemptions in the source state that were granted under the 1986 Treaty for an interest payment made to, inter alia, entities wholly owned by the state. At the same time, it clarifies that this category of lenders explicitly includes Cassa Depositi e Prestiti, SACE and SIMEST which - under the 1986 Treaty – had lost their exemption as they were no longer wholly owned by the State.

A further exemption applies to interest paid by the above-mentioned public financial institutions to Chinese residents in respect of debt securities denominated in Chinese currency and issued directly in China (so-called panda bonds), thereby encouraging this type of instrument.

The 1986 Treaty set a 10% limit on the taxation of royalties in the source state, and this is confirmed in the New Treaty. However, the New Treaty introduces a lower rate of taxation on payments related to the use of, or the right to use, industrial, commercial, or scientific equipment. The 10% rate will be applied to 50% of royalties (instead of the 70% that was previously applied), leading to an effective tax rate of 5%. The explanatory notes state that this lower rate is the most favourable out of all the tax treaties China has with EU countries.

The New Treaty confirms that capital gains are taxed in the state of residence of the transferor and in the country where the property is located, if the properties are:

• Immovable properties;

• Movable properties forming part of the business property of a permanent establishment;

• Shares deriving more than 50% of their value directly or indirectly from immovable properties; and

• Shares representing a participation of at least 25% of the capital of a company (a Qualified Stake).

In contrast to the 1986 Treaty, any capital gain not included in these categories will be subject to taxation exclusively in the state of residence of the alienator.

The convention does not limit the amount of taxes that the source state can apply to capital gains, which could hence be levied according to domestic tax rules. The following should therefore be noted:

• The Chinese domestic tax rate applicable on capital gains from the sale of shares held in a Chinese entity derived by non-residents (10%) is higher than the tax rate applicable to dividends paid out of a Qualified Stake under the New Treaty (5%). Such differential may encourage cash-out policies aimed at switching from taxation of capital gains to dividend taxation.

• Chinese companies holding a Qualified Stake in Italian companies would be subject to a final 26% substitute tax on the entire amount of the capital gain since they are not eligible for the reduction to 5% of the taxable base of capital gains from qualified shareholdings granted to corporations resident in a state of the EU or of the European Economic Area allowing exchange of information (Article 68, paragraph 2-bis, Presidential Decree No. 917/1986). This exclusion might breach the free movement of capital principle laid down by Article 63 of the Treaty on the Functioning of the European Union, which can also be claimed by non-EU investors.