In mid-February the Chinese tax authorities issued Guoshuifa  19 (“Circular 19″). Circular 19 outlines the State Administration of Taxation’s new administrative approach to collecting tax from non-resident enterprises. Prior to discussing the changes introduced in Circular 19, it is apt to briefly outline the general rules for the taxation of non-resident enterprises.
Taxation of Non-resident Enterprises
The taxation of non-resident enterprises depends upon whether they have a “permanent establishment” in China. Non-resident enterprises that do not have a permanent establishment will be liable to tax at 10% on income sourced or “derived” from China. Non-resident enterprises that do have a permanent establishment in China will be subject to tax at 25% on income (derived outside or inside of China) that is attributable to the permanent establishment.
Circular 19 applies to non-resident enterprises whether or not they have a permanent establishment in China. Article 3 of Circular 19 simply requires non-resident enterprises to maintain accurate accounts and to pay enterprise income tax in accordance with the income in those accounts.
Article 4 then provides that where accurate accounts have not been maintained, the authorities may deem the enterprise to have a specified profit level. There are three methods for deeming the requisite profits. The deemed profit rates under Article 4 will generally be more relevant in the case of a permanent establishment and is similar to the treatment of representative offices under Circular 18.
Article 5 then provides a deemed profit rate in respect of particular transactions. These profit rates are as follows:
- Engineering contracts, design, and labor consulting contracts – 15%-30%;
- Management services – 30%-50%; and
- Other labor services, or other operations – no less than 15%.
The tax authorities may impose a higher rate where they consider the actual profit to be higher. It is not clear whether Article 5 applies when a non-resident enterprise can, through accurate accounting records establish that their profit rate on a particular transaction is lower than the prescribed levels. On a fair reading of the Circular, it seems that the better argument would be that these rates apply regardless.
Accordingly, from this there are two important things note:
- Any company that does not presently operate a business in China but does enter into business arrangements with Chinese resident companies should review such arrangements to ensure that their actual profit is at least of that prescribed rates.
- Not all such arrangements will result in the income being regarded as income sourced from China. However, it is imperative for non-resident companies to consider whether Chinese tax will apply in the circumstances and whether any alterations to an arrangement can be made to ensure that it does not.
Circular 19 does discuss a few other issues, including indicating a minimum 10% profit rate for the sale of machinery or merchandise by a non-resident enterprise to a resident enterprise, but the above are the main salient points for companies contracting with Chinese companies, or who have a permanent establishment, to consider.
In 2008 China dramatically reformed its taxation system through the introduction of the Enterprise Income Tax Law. There were two substantial changes brought about by the EITL. Firstly, it removed the previous tax distinction for domestic enterprises and foreign invested enterprises (FIEs) under which FIEs had been subject to a highly concessional rate of tax. The second significant change was the introduction and strengthening of China’s international anti-avoidance rules. This included a wider definition of a tax resident company, the introduction of rules relating to thin capitalisation, extensive documentation requirements in respect of transfer pricing, the introduction of a general anti-avoidance rule and controlled foreign company rules.
Throughout 2008 and 2009 various regulations, measures and circulars were promulgated at all levels of the tax administration system for the purpose of implementing the new law. The SAT spent much of 2009 assembling an large enforcement team and hired 500 more officials. One common theme in all of this was the push to target the shifting of profits off-shore. It had been quite a common practice, up until 2008, for foreign invested enterprises to effectively generate no profit in China through an array of related party transactions. As a result of this new environment, nearly all foreign invested enterprises have had to undertake a review of their structures.
It is also important to note that, and in the usual manner of Chinese bureaucratic politics, traditionally local tax bureaus only sporadically, if at all, followed the mandate of the State Administration of Taxation (SAT). This was because the local tax bureaus were also answerable to the provincial and local level governments. Such governments were more interested in encouraging investment in their regions, then ensuring that national level policies were followed to the letter of the law. Accordingly, many legal and non-legal concessional arrangements were entered into at a local level. However, more recently there has been a growing willingness by the local tax officials to follow intructions from the national guys. This has three potential implications. Firstly, we can expect national level policies to enforced more effectively and consistently at a local level. Secondly, many non-legal concessional tax arrangements that were entered into in the past may no longer receive protection by the local officials. Thirdly, it will be less likely that such arrangements will occur in the future.
Yet, we are yet to feel the full brunt of the changes. This is because the tax authorities, whilst having undertaken internal reviews of files, have generally not put taxpayers on notice that they are being subject to an investigation in respect of the 2008 year. The authorities commenced their internal reviews in May/June 2009 and, from what we have been told, will commence sending out notices of tax adjustments in the first quarter of this year. Interesting times ahead – for us anyway.
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.