Targeting of Permanent Establishments

Posted by on January 15, 2010 under Corporate Tax Planning, International tax | Be the First to Comment

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 -

  1. 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,
  2. 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.