On November 10th 2010, the State Council issued “Administration Rules on Registration of Permanent Representative Office of Foreign Enterprises” (Decree of State Council No 584), which will be implemented on March 1st 2011. Decree No 584 abolished “Administration Measures on registration of representative office” of 1983, set systematic administrative rules on setting up, changing or terminating representative offices, and increased punishment to irregular behaviors of representative office.
According to Decree No 584, foreign enterprises could set representative offices in China only if established at least two years, the amount of representatives is at most four. Decree No 584 adds regulations that persons who have been given criminal penalties due to damaging nation security or public interest should not be chief representatives. In addition, Decree No 584 enlarge the scope of documentations that need to be reviewed when foreign enterprises apply to set up representative offices, such as foreign enterprises’ articles of association or organization agreements and so forth. Representative offices apply to postpone registration, the application period is changed from “thirty days before expire date” to “sixty days before expire date”. According to Decree No 584, representative offices should submit yearly report to registration authorities between March 1st and 30th June, and make disclosure of existence, business development and cost and revenue statement of foreign enterprises. To enterprises unregistered and setting up representative offices without authorization or engaging representative office business, the penalty raised to “between fifty thousand and two hundred thousand Yuan” from “under one ten thousand Yuan”. To behaviors that representative office engage in profit-making activities, the penalty raised from “twenty thousand Yuan” to “between fifty thousand and five hundred thousand Yuan” and stipulate to make relevant property confiscated and cancel registration license to serious cases, which is stricter than previous regulations.
Since 2010, State Administration of Industry and Commerce, the Ministry of Public Security and SAT issued a series of regulations to make higher requirements to the supervision and regulation on representative offices of foreign enterprises. Hence, investors should pay more close attention to the business scope of representative offices, restriction to business activities of representative offices and stricter regulations on representative offices to safeguard enterprises’ legal interest.
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.
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.