Posted by Matthew on March 31, 2010 under Corporate Tax Planning, International tax | 
fter the last few weeks I have given some thought about Circular 18 and whether I think the changes are appropriate or not. I have now decided that I am not a fan of it. Why? Because it perpetuates the notion, which is incorrect as a matter of law, that representative offices (ROs) in China have a separate legal personality. Let me explain why it does this and the problems it causes.
As most people know, ROs are not meant to be, subject to limited exceptions in respect of banks and professional service firms, utilised to carry out direct business in China. Rather, China requires foreign companies to establish a local company (a WFOE or JV) or, as of 1 March 2010, a registered partnership in order to undertake direct business here. This is no different from most jurisdictions. Australia, for example, requires foreign companies to register under the Corporations Act if they wish to carry out business.Yet, over time many ROs flagrantly breached this restrictions. More accurately I should say that many foreign enterprise utilised ROs as vehicles to undertake direct business contrary to the restrictions. This was a function of the high set-up costs for WFOEs and JVs and the requirement that such entities have a limited amount of registered capital – as an aside, I have always thought that in most cases the fear of registered capital requirements was rather strange. Who would consider establishing a business without having the necessary capital to meet initial (say first 2 years) costs? In a classic RO, the RO should never be taxable because it is really the parent company that is earning the income. The parent company should be taxed in that income – where it relates to a permanent establishment (which a RO would nearly always be) this would be at 25% and otherwise it would be at 10% as withholding tax.
However, in response to the fact that ROs were, in truth, engaging in direct business and earning income, the Chinese tax authorities sought to impose tax on them. As ROs rarely kept good accounting records (in part because they wished to avoid the perception that they were engaging in direct business and hence would not report the earning of income), the tax authorities decided to deem a ROs income based on the amount of their expenses. Expenses relating to the classic use of an RO (liaison office, marketing, promotion of goods of parent co etc) were exempt from this deeming because the RO was never intended to be taxed on such income. A lot of this was moot because a large majority of ROs actually received exempt status on all income from local tax officials are part of the policy on encouraging foreign investment in that local area – as a further aside, I have always found China’s pre-2008 tax policy fascinating and have thought that it is a great example of what the OECD refers to as “harmful tax competition”.
Circular 18, by contrast, taxes ROs on any income that is attributable to the RO – this would include income from direct business and income of the foreign parent that is attributable to the activities of the RO. Circular 18 removes both the outright exemptions and the exemption on expenses relating to the foreign parent noted above. In effect, this means that an RO will be the relevant taxpayer for the income of a non-resident enterprise and the income attributable to the RO will be taxed at 25% in accordance with the Enterprise Income Tax Law (EITL). Article 3 of Circular 18 provides as follows:
Article 3: Representative office shall apply and pay the enterprise income tax on its incomes, and apply and pay business tax and value-added tax on its taxable incomes.
Where the RO has not kept accurate accounting records, the tax authorities will again deem a profit – 15% of expenses. My problem with this is following:
- Strictly speaking the relevant taxpayer in respect of the income of a non-resident enterprise should be the non-resident enterprise. Now, whilst in practice imposing tax on the RO as opposed to the non-resident enterprise should not result in any difference, it is an example of expedience over legal consistency. ROs are not enterprises so should not be taxed under the EITL.
- If the SAT wishes to utilise ROs as withholding agents for the income of the non-resident enterprise, which is understandable, then they should make this clear. This would be an approach that is legally consistent and achieves the objectives of effective tax collection. Unfortunately, Circular 18 precedes on the basis that the RO is the relevant taxpayer and is not merely a withholding agent.
Circular 18 represents a messy approach to a rather simple problem.
This is more than just a philosophical objection – a legitmate questions arises as how ROs will operate in the context of China’s double taxation agreements (DTA) and, in particular, whether they will be regarded as companies for those DTAs and, in fact, whether the DTAs should apply to ROs themselves (as opposed to the parent companies). Now, interestingly Circular 18 indicates that DTA relief will be available for ROs (see Article 10 of Circular 18). I am not confident that this is strictly correct. Let me explain why
As I usually do I will utilise the China-Australian DTA as an example (dont worry most DTAs are pretty much the same so the points I raise here will be of general application). Article of the DTA provides that the agreement:
shall apply to persons who are residents of one or both of the Contracting States.
Article 3 then provides the following definitions:
(d) the term “person” includes an individual, a company and any other body of persons;
(e) the term “company” means any body corporate or any entity which is treated as a company or body corporate for tax purposes;
Under this definition, the question of whether an RO is a company, and hence a person, for the purposes of the DTA is dependent on whether they are treated as a company for tax purposes. Under a strict reading of the EITL, ROs are not treated as companies for the purpose of Chine tax purposes – they do not fall within the definition of enterprise. However, Circular 18 seems to treat them as such in saying that the EITL applies to them . Can ROs then be regarded as resident companies for the purposes of China’s DTAs? Interesting dilemma and to be honest there is no easy answer. Does anyone else have any other ideas?
Despite the title of this post there is really only ugly here.
Posted by Matthew on January 29, 2010 under Anti-Avoidance, Corporate Tax Planning, International tax |
The following scenario is one that we have seen a lot. This relatively simple structure arose out of a lack of vigilance by the tax authorities in respect of cross-jurisdictional transactions. However, the current tax environment is markedly different from when this structure became popular. There are some aspects of this structure which are quite justifiable, meaning it wouldnt take much to make it tax compliant. The major concern with this structure is that it is unlikely to result in any major tax savings as the US corporate tax rate is higher than the Chinese rate (particularly if the company is entitled to high tech incentives).
The scenario:
Parent company is located in the US (for example) (“Parent Co”). Parent Co undertakes services for Multinational Group, a company with its head office in the US. Multinational company sets up operations in China. Parent Co sets up a WFOE to provide similar service to those operations. Multinational Group pays parent company in the US. Parent Co then “hires” the WFOE to undertake the services in China. Parent Co pays the WFOE a service fee that is sufficient to cover expenses and no more. WFOE makes no profit and pays no taxes in China. It should be noted that in most cases the client has no option but to utilise the Parent Co/WFOE structure because of the requirements set out by the Multinational Group i.e. the Multinational Group wishes to contract with the Parent Co and not via the Chinese enterprises.
This structure has been quite common in China in the past because the tax authorities did not aggressively attack off-shore income nor greatly utilise the transfer pricing provisions. There are several potential problems with this scenario in light of the current tax environment:
Transfer pricing problem: structuring a service fee between related parties so that the fee merely covers the expenses of the WFOE is not an acceptable method of transfer pricing. On a general level, service fees between related party needs to be provided at a rate comparable to the market rate for the provision of such services. The SAT has indicated early last year that it will particularly target companies that are not making profits (or are making losses) in China.
Solution: To remedy this structure from a transfer pricing perspective there is a need to impose an appropriate fee between the two companies. In practice, this can actually be quite difficult. It is important to keep extensive documentation establishing the basis on which any pricing decision is made. This includes the manner in which the business is operated. China’s transfer pricing regulations contain 5 different methods for determining the appropriate price. Which method should be used is dependent upon the various circumstances and such selection can greatly impact upon the price adopted. Transfer pricing heavily depends on comparable factors. A comparability analysis examines the functions and risk of a particular enterprise and seeks to find comparable.
Anti-avoidance problem: China’s General Anti-Avoidance Rule (GAAR) permits tax officials to make a tax adjustment where an arrangement has been entered into for the purpose of tax avoidance. The rule was only introduced as part of the 2008 changes. The GAAR has been relatively under utilised at this stage and an exception to its application is where a transaction has a reasonable business purpose. Here, the fact that the multinational company is requiring Parent Co to adopt such a structure should be provide a sufficient basis to argue that it is has a reasonable business purpose for entering into the transaction.
Solution: The best solution to this problem is to ensure that the transfer pricing is appropriate in line with point 1 above as this will likely remove any avoidance argument. Secondly, it is important to document that the transaction was entered into for commercial reasons as opposed to tax avoidance – the fact that such a structure was required by the non-related party. If these approaches are taken then the risk here if effectively eliminated.
Permanent Establishment Problem: there is a relatively small risk that the tax officials will deem the WFOE to be a permanent establishment of Parent Co in China and therefore the income of Parent Co will arguably be taxable in China. This is a very slight risk given current practices of the tax authorities in China. The fact that it is separate entity will generally, although not completely, negate the argument of a permanent establishment.
Solution: There is little that can be done to avoid such a problem other than to document that the two companies operate independently. It would be beneficial if the WFOE was doing other business in addition to what it does for Parent Co, although that would not be determinative. The risk here is very small if the transfer pricing has been done appropriately.
Business Tax: It is highly likely that no business tax is being paid on money paid between the two US companies. Presumably, business tax is paid on the services provided between Parent Co and the WFOE, although the turnover is lower than what it should be because the agreement is merely to cover the WFOE’s expenses. The problem here is that Article 7 of the Business Tax Regulations provides the tax authorities with the power to make an adjustment where taxable services are provided at significantly low prices without justifiable reasons. The authorities can also impose penalties and interest.
Solution: The problem can be resolved by adopting an appropriate transfer pricing policy in accordance with point 1. In such a case, it will be difficult for the tax authorities to argue that the price is significantly low and the risk is removed.
Posted by Shi Zhiqun on January 27, 2010 under Corporate Tax Planning, International tax |
The failure by Taiwan and China to reach agreement on a Double Tax Agreements looks like it will adversely effect airlines operating across the strait.
The talks between China and Taiwan in December 2009 did not achieve a final agreement but it was agreed that airlines from both sides would receive interim preferential tax treatment. China had implemented its side of the bargain, waiving income and business tax on China Airlines and EVA Air, the two Taiwanese airline. However, Taiwan’s commitment could be satisfied as the relevant law has yet to pass through the Taiwanese legislature.
Accordingly, China has now asked the two airlines to pay back taxes to December 2009. China Airlines has applied to defer the tax, although it is not clear on what basis. EVA Air did not receive the official waiver originally and, as such, has not been able to transfer its earnings out of China as it does not have a tax clearance certificate as required by China’s FOREX regulations.
Posted by Matthew on under Corporate Tax Planning, International tax |
On 25 December 2009 the State Administration for Taxation and the Ministry of Finance issued the “Notice on Foreign Tax Credit Issues for Enterprise Income Tax” (Caishui [2009] No. 125) (“Circular 125”), outlining more detailed rules in respect of claiming foreign tax credit relief under the Enterprise Income Tax Law (“EITL”). Under Article 23 of the EITL is tax credit is provided in respect of income for which foreign tax has already paid by the resident taxpayer (“direct FTC”). Article 24 of the EITL extends the credit to where the resident taxpayer has received dividends and similar proceeds from shares in a foreign enterprise and that foreign enterprise has already paid tax on its profits in the original jurisdiction (“indirect FTC”). Articles 80 and 81 of Implementing Regulations of the Enterprise Income Tax Law (“IREITL”) limit the availability of this indirect tax credit to where the resident enterprise holds more than 20% of the equity in the foreign enterprise.
It is important to note that under the EITL, tax resident enterprises are subject to tax on their worldwide income. Where foreign sourced income is taxed in the country of source (which will usually be the case) the potential for double taxation arises. Accordingly, the FTC rules aim to prevent such double taxation. However, at the same time, the rules need to be designed to avoid potential abuse of the FTC. One manner in which the EITL prevents abuse is to limit the FTC to the tax amount that is payable under the EITL (the “FTC Limit”). Under Article 78 of the IREITL, this limit is to be calculated on a jurisdiction by jurisdiction basis in accordance with the formulabelow：
FTC Limit： Enterprise’s Total China Tax Liability on Worldwide Income x Taxable Amount of Specific Foreign Sourced Income) / total taxable worldwide income
EXAMPLE: An example can best illustrate the operation of the FTC. China Co has $1000 ($700 sourced from China and $300 sourced from the United States) of taxable income worldwide. This gives rise to a tax liability of $250 in China. Accordingly, the FTC Limit is calculated as follows – $250 x $300 / $1000 = $75. $75 is therefore the allowable FTC Limit in respect of China Co’s US tax liability.
Qualifying Taxes
Under Article 77 of the IREITL, only taxes which are “in the nature of income taxes” are entitled to an FTC. Unfortunately, Circular 125 does not clarify what is meant by “in the nature of income taxes”. This is highly unlikely to include transactional taxes, such as VAT or GST, but would most likely include withholding tax. It is anticipated that clarification will be given in this area in the future. Circular 125 then lists certain specific payments that will not qualify for the FTC, including (inter alia):
- Foreign income taxes that, although they have been paid, should not have under foreign jurisdiction’s income tax laws and regulations;
- Interest or penalties incurred because of the non-payment or late payment of foreign taxes; and
- Foreign income taxes that will not be paid because of the operation of a double tax agreement;
Indirect FTC and interposed entities
Circular 125 permits tax resident enterprises to “look-through” interposed entities for the purpose of the Indirect FTC In other words, where dividends or similar payments, on which tax in the nature of income tax has already been, are made by a foreign enterprise to an intermediate holding company, the tax resident enterprise will be entitled to a FTC in respect of the tax paid by the original enterprise. However, this look-through ability is limited to three tiers. Further, in order to qualify to “look-through” there must be a 20% holding at each level of the chain and, the tax resident enterprise must hold, directly or indirectly, hold 20% in the relevant foreign enterprise. The diagram below illustrates these holding requirements in respect of two-tiers:
Simplified Calculation of FTC Limit
In certain circumstances Circular 125 allows a simplified calculation to be used for the FTC Limit. For the purposes of the Indirect FTC, where the tax resident enterprise is unable, because of reasons outside its control, to establish the income tax liability for the foreign country, the FTC Limit will be 12.5% of foreign source income, except where the tax rate of the respective source jurisdiction is lower than 12.5%. Where source jurisdiction’s tax rate is “significantly higher” than China’s tax rate, China’s 25% corporate tax rate will be the relevant multiplier. Circular 125 lists the following countries as having a significant higher tax rate than China: Argentina, Bangladesh, Burundi, Cameroon, Cuba, France, Japan, Jordan, Kuwait, Laos, Morocco, Pakistan, Syria, the U.S. and Zambia. It should be noted that the simplified approach does not negate the need for the tax resident enterprise to produce the relevant tax certificates or other proof of payment of some tax.
Inability to calculate FTC accurately
Apart from where the conditions exist to use the simplified approach, if the tax resident enterprise is unable to accurately calculate the FTC Limit in respect of a particular country, then they will not be entitled to claim the FTC in China.
Tax Treatment of Income from Foreign Branches
Tax treatment of “foreign branches without separate taxable status” is explained under the Circular. This entity is basically a foreign branch of a resident taxpayer that is not a legal person under the relevant foreign laws or is not a tax resident in accordance with a double tax agreement. Circular 125 confirms, this simply restates the general operation of the EITL in respect of worldwide income, that the foreign sourced income of such entities must be included in the taxable income of the resident taxpayer. Similar to the position generally with foreign branches under Article 17 of the EITL, resident taxpayers are not entitled to deduct foreign losses relating to their “foreign branches without separate taxable status” from domestic profits.
Circular 125 also notes that, in respect of a branch which is a taxable entity in the foreign jurisdiction, expenses which are common to both the foreign operations and the China operations should be allocated on a reasonable basis. No guidance is given as to what will constitute a “reasonable allocation”.
Circular 125 applies retrospectively from 1 January 2008.
Posted by Matthew on January 15, 2010 under Corporate Tax Planning, International tax |
In 2010 it is our prediction that the SAT will adopt a far more aggressive approach with respect to permanent establishments – an area where they have traditionally not been too concerned (Wikipedia provides a rather bad explanation of permanent establishments here but it does provide a vague idea of the concept). We have a few reasons for this prediction. Firstly, the practice of not taxing foreign enterprises in relation to permanent establishments was a part of China’s former attitude to encourage foreign investment at all costs. The EITL reflects that China no longer adopts this “at all costs” approach. Secondly, such an approach is consistent with Measures No. 6 that was released last year. Measures No 6 would be pretty impotent if the authorities were not going to take a harder line approach to permanent establishments. Three, it is consistent with public comments from the SAT in early 2009.
By way of explanation, there are basically two basis on which companies are taxable in China -
- where it is a resident company for tax purposes (in which case it is taxable on its worldwide income, subject to available double tax relief) or,
- in respect of non-resident companies, where the income is sourced from China.
The question of whether income is sourced from China depends upon the circumstances. In relation to the sale of goods, it is the place where the transaction is carried out. China’s right to tax non-resident companies on China sourced income is subject to an applicable double tax agreement (DTA) providing otherwise. All of China’s DTAs deny China’s right to tax companies resident in the other jurisdiction in respect of business profits, except, and this is a big exception, where those profits relate to a permanent establishment that the company has in China. [For a more comprehensive discussion on liability for tax in China see here].
The definition of a permanent establishment is quite wide and it is sufficient to note, for the purpose of the point I am about to make, that a representative office will definitely fall within the definition. It will be interesting to see whether the taxation of ROs changes in light of the stronger push on permanent establishments. It is my prediction that a higher tax liability will be imposed on some foreign enterprises (particularly those in which the RO itself is tax exempt) in the future. When you combine this with the fact that ROs do not enable good, smart tax planning structures that corporate entities permit – a basic example would be licensing fee from the parent to a WFOE in order to generate an expense to deduct in China - the overall tax difference between a WFOE and a RO, if my predictions are correct, may be quite significant. Our indications are also that less and less ROs will be approved, primarily because they are not favoured by the tax officials in China – they may be a dying breed.
The issue of a permanent establishment is really only relevant in relation to foreign companies that operate in China without a corporate entity (ROs are not corporate entities) because it is very rare for tax authorities to hold that a subsidiary company is a permanent establishment. Although there is some debate on this issue. For a good article, in a non-China context, on whether a subsidiary will be a permanent establishment see http://www.ctf.ca/PDF/07ctj/2007ctj2-taylor.pdf. If the China sourced profits are being inappropriately allocated to the parent company, then the issue will, generally, be one of transfer pricing or anti-avoidance rather than taxing the parent company for having a permanent establishment.
