Changes begin – first reported decision
As we mentioned in the March edition of Hwuason Insights, significant changes have been implemented in the manner in which representative offices (ROs) are taxed in China (see Circular 18). The first quarter (the reportable tax period for ROs) ended on 31 March 2010 and accordingly we are now beginning to see the interpretation of the new rules by the local tax authorities.
In early April the Shajing Local Taxation Office in Shenzhen province re-assessed 15 ROs and increased the payable tax by almost RMB700,000. As part of the new tax environment for ROs, the Shajing Local Tax Office examined these ROs and discovered that the ROs had only paid their income tax to the state tax bureau but had not met their taxation obligations with the local tax bureau. The chief representatives of the RO were required, as part of these investigations to have discussions with the local tax officials in relation to the nature of their business.
The tax officials also examined and compared the materials provided by the ROs. As part of this process, the ROs indicated that there were some ambiguous aspects to the new policies. As transitional concessional arrangement, the local tax officials provide some guidance of the new policy to the ROs. However, it cannot be expected that the officials will take such a conciliatory approach in the future. These turn of events reflect the general cynicism of tax officials towards ROs in China. It can be expected that a continued tough line will be adopted by tax authorities in China in relation to the tax practices of such structures.
Actual income confusion
There has been some confusion recently relating to the SAT’s treatment of ROs (in Circular 18) and the treatment of them by the State Administration for Industry and Commerce (SAIC in that the SAIC rules provide that ROs could not undertake direct business in China, yet the Circular 18 indicates ROs may be taxable on actual income. A question has arisen, from some, as to how an RO can have actual income if it is not able to undertake direct business. What this question misunderstands is that representative office are assessed and required to pay enterprise income tax on its attributable income. The term “attributable income” has a very specific meaning in international tax – it is commonly used in terms of taxing companies in respect of “permanent establishments” they have in a foreign country. Income could be attributable to a source (such as an RO) without that source actually directly earning the income. In other words, the parent company of an RO will often earn income that could be attributable to the RO without the RO engaging in direct business. This is actually the classic model of an RO. In such circumstances, Circular 18 is saying that China will tax the RO on that income and in order for the foreign investor to avoid either of the two deemed methods, accurate accounting records need to be maintained to reflect what income is attributable to the RO.
Regardless, it should be noted that the SAT has no legal authority to indicate what business activities are lawful for an RO to operate. At the same time, the SAT will treat legal and illegal income equally – it will tax them. A drug dealer cannot resist tax on the basis that his/her income derives from the proceeds of a criminal act. Such an argument that the “inconsistency” between Circular 18 and the SAIC Notice requires clarification is therefore misguided.
Hwuason Seminar Series
The End for Representative Offices?
On 20 February 2010 the State Administration of Taxation issued Circular 18/2010 outlining a new tax treatment for representative offices (ROs) of foreign enterprises in China.
Circular 18/2010 replaces several older circulars relating to the taxation of ROs and introduces significant changes. The new circular represents a fundamental shift in tax liability for ROs in China and all foreign companies with ROs should determine how it affects them. Hwuason’s tax lawyers will outline the changes and illustrate how they will impact upon the bottom line
Issues covered will include:
1. Previous tax treatment of ROs;
2. An outline of Circular 18 and its practical implications; and
3. Moving from a RO to a corporate structure.
For those unable to attend the seminar but who would like more information in relation to this latest development, please do not hesitate to contact us.
Date: Wednesday, 21 April 2010
Time: 2pm to 3pm
Location: Hwuason Boardroom, Suite 1505, Tower B, Jianwai SOHO, No 39, East 3rd Ring Road,
Chaoyang District, Beijing
Hwuason is the first law firm in China specialized in taxation law. Hwuason has extensive experience in tax planning, corporate finance, foreign investment, M&A and tax related litigation.
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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.
On 20 February 2010 the State Administration of Taxation (SAT) issued Guoshuifa  18 (the “Circular”), a circular outlining a new tax treatment for representative offices (ROs) of foreign enterprises in China. The Circular replaces several older circulars related the taxation of ROs and the changes are quite significant.
End of Tax Exemption for ROs
In the past, a large number of ROs were exempt from tax in China. The Circular now indicates that the exemption for ROs is to end – both for ROs established in the future and currently existing ROs that are tax exempt. This means a radical shift in profitability for foreign enterprises that had operated in China with such an exemption.
The Taxable Income of the RO
The Circular provides three bases on which the taxable income of a RO is determined; the actual method and two deemed methods. The actual method will apply where the RO can adequately prove gross income and expenses. A similar actual method applied in the past, but in practice it was only used with respect to professional services firms. It is not clear whether the actual method under the Circular will be similarly limited.
The two deemed methods apply where the income of the RO or the expenditure of the RO cannot be adequately established. In such, circumstances the Circular deems the taxable income of the RO to be a minimum of 15% of expenditure or gross income (whichever applies). Under the previous system, the deemed taxable income was 10% so the new Circular will lead to a higher level of taxable income for ROs using the deemed method. The fact that the deemed profit rate is a minimum amount means that local tax officials will have the discretion to impose a higher rate. Once the deemed taxable income is determined, it will then be taxed at the applicable EITL tax rate, which as indicated above will likely be 25%. As a result of all this, where minimal profit is being made by the RO, the Circular provides a strong impetus to keep accurate and sound accounting records so that the actual method can be applied.
Repeal of Guoshuifa (1996) 165
One of the more significant aspects of the Circular is that it repeals Guoshuifa (1996) 165 (“Circular 165”) without addressing matters covered in that circular. Circular 165 indicated what activities of a RO would be taxable and what activities would not be taxable. Non-taxable activities included work carried in relation to the production, manufacturing and sale of the head office’s products, market research, and liaison work. As Circular 165 has been repealed and no mention of non-taxable activities has been made in the Circular, we must assume, unless a further circular is issued, that all activities of ROs will be taxable in the future. We understand that tax officials have had long-held concerns about RO’s false characterisation of activities to fall within the exception and this may explain why this practice is not continued in the Circular.
The Circular represents a fundamental shift in tax liability for ROs in China and, as such, all ROs need to determine how it affects them and impacts upon their profitability.