Re-evaluating Tax Assessments for Representative Offices

The main importance of the new regulations is in the fact that foreign companies that provide certain types of services as defined under the 2003 Circular are, with effect from July 1 2003, required to follow a new tax assessment methodology in reporting Chinese taxes for their representative offices established in China. Their representative offices will be obliged to report Chinese taxes based on actual revenues and actual profits that they earn from services provided inside China.

Analysis of the Rules

Tax-exempt Representative Offices

The management of foreign companies are often puzzled by the fact that their representative offices (RO) in China are liable to pay Chinese taxes. They argue that the ROs only perform non-profit-making liaison and promotional activities.

From a Chinese tax perspective, an RO may either be taxable or tax exempt, depending on the nature of its activities. Some of the activities of an RO are tax-exempt and some are taxable. In practice, unless an RO only performs tax-exempt activities, it will be required to pay Chinese taxes.

The prevailing tax rules and practice in China limit the application of tax-exempt treatment to a great extent.

ROs owned directly by manufacturing companies are exempt from Chinese taxes on the condition that the ROs do not perform any activities other than those of a preparatory nature in connection with the supply of goods to China produced by the manufacturing companies. Tax-exempt activities may include market study and customer liaison.

ROs owned by foreign commercial banks are also exempt from Chinese taxes on the condition that they assume a customer liaison role only.

New Tax Rules for Representative Offices of Service Companies

Prior to July 1 2003, representative offices established by foreign companies were usually required to pay Chinese taxes based on costs and expenses incurred by the ROs, regardless of whether the ROs actually conducted any business activities in China or derived any revenue from the services, if any, that were provided in China. This is commonly known as the cost-plus method. Arithmetically, it works as follows:

Costs and expenses

Business Tax = x 5%

(1 - 15%)

Costs and expenses

= x 10% x 33%

(1 - 15%)

Business Tax is a type of cumulative turnover tax payable, inter alia, on revenue generated from services provided in China.

The above formulae indicate that an RO is currently deemed to have provided taxable services in China and is also deemed to have derived taxable revenue based on grossing up RO costs and expenses by 15%.

In accordance with the 2003 Circular, effective July 1 2003 an RO will no longer be required to use the above cost-plus method in determining its Chinese tax liabilities if the foreign company, which owns the RO, engages in any of the following businesses:

• provision of professional services, such as legal, tax, accounting, audit, etc.;

• provision of commercial and business services; or

• provision of other professional and consulting services

It is now mandatory for these types of ROs to compute their respective Chinese taxes based on the actual revenues and profits that they derive from services provided in China.

These ROs are also supposed to keep full sets of accounting books and records in China for Chinese tax reporting purposes.

In their present form, the new rules do not provide a clear definition for commercial and business services; these may then potentially be construed to have a broad interpretation to include procurement services and product promotion and marketing services.

Status Quo Maintained for Other Types of Representative Offices

Foreign companies in the businesses of advertising, tourism and general trading and distribution should continue reporting Chinese taxes for their representative offices in China by applying the cost-plus method.

Evaluating the New Rules

A Natural Development

The 2003 Circular is basically in line with the fundamental tax principles established in the prevailing corporate income tax rules and regulations.

According to the PRC Foreign Investment Enterprise and Foreign Enterprise Income Tax Law (the Foreign Enterprise Income Tax Law), with effect from July 1 1991, taxable establishments (defined to include ROs) of foreign companies are liable to pay taxes based on actual revenues and actual profits derived from sources inside China. Nevertheless, local Chinese tax offices have not been active in pursuing tax assessments on ROs based on actual China-source revenues and profits, partly due to a presumption that ROs should not conduct any business in China.

However, China's entry into the WTO has opened a new avenue whereby cross-border supplies of professional and consulting services have become permissible immediately upon WTO accession.

For example, in the past China tightly restricted the operation of foreign law firms and accounting firms. As most readers are aware, per the terms of China's WTO accession agreement, China has committed to opening a broad range of markets, including legal, accountancy, taxation, management consultancy, architecture, engineering, urban planning, medical and dental, and computer-related services. China now permits foreign majority control in all of these areas, except for the practicing of Chinese law (which is an exception common to many WTO members). For accountancy, China has agreed to eliminate a mandatory localization requirement and will now allow unrestricted access to its market to licensed professionals and will follow transparent procedures.

ROs of foreign law firms are, contrary to the general rules on representative offices, now permitted to engage in profit-making activities, collect service fees locally in China and to issue official Chinese invoices to their customers in China. To a large extent these ROs operate like full operating branches.

To recap, ROs of foreign law firms are permitted to engage in the following business activities:

(a) providing clients with consultancy on the legislation of the country/region where the lawyers of the law firm are permitted to engage in lawyer's professional work, and on international conventions and practices;

(b) handling, when entrusted by clients or Chinese law firms, legal affairs of the country/region where the lawyers of the law firm are permitted to engage in lawyer's professional work;

(c) entrusting, on behalf of foreign clients, Chinese law firms to deal with Chinese legal affairs;

(d) entering into contracts to maintain long-term entrustment relations with Chinese law firms for legal affairs; and

(e) providing information on the impact of the Chinese legal environment.

Entrustment allows the foreign representative office to directly instruct lawyers in the entrusted Chinese law firm, as agreed between both parties.

These types of ROs are, in compliance with the 2003 Circular, liable to pay Chinese taxes based on actual revenues and actual profits derived from services rendered in China commencing from July 1 2003.

Avoidance of Double Taxation

Prior to issuance of the 2003 Circular, double taxation would potentially be created in situations where an overseas consulting firm would supply services to its customer in China with assistance provided by an RO of the firm in China. The firm and its RO would be regarded as two separate taxpayers. The firm would pay taxes based on gross service fees received from the Chinese customer, whereas the RO would pay taxes based on costs and expenses that the RO would incur. Costs and expenses of the ROs would not be deductible against the firm's taxable service fees in China.

According to the 2003 Circular, the aforesaid RO in China will, starting from July 1 2003, have a filing position to report its Chinese taxes based on a fair share of the service fees paid by the customer. Taxable revenue of the overseas consulting firm may be reduced accordingly, and hence exposure to double taxation may be minimized.

Further clarification from the SAT is necessary in order for taxpayers to fully exploit the potential tax benefits outline above. In particular, how will the 2003 Circular interact with other current tax rules and regulations? For example, will a Chinese customer be able to remit service fees to an overseas consulting firm if part of the fees would be reported as Chinese taxes under the name of the RO instead of the consulting firm?

Bookkeeping Requirements

ROs that report Chinese taxes under the cost-plus method will keep their accounting books and records on a cash basis. Specifically, costs incurred in the acquisition of durable goods, such as office equipment and leasehold decorations, may not be capitalized, but expended upon payment.

In the absence of further clarification from the SAT, it is uncertain whether an RO that reports Chinese taxes based on actual revenues and actual profits would be permitted to claim deductible expenses on a cash basis for the purpose of computing its corporate income tax liabilities. It is equally unclear whether those ROs will be obliged to prepare accounting books and records in accordance with the prevailing Chinese accounting rules that make accrual accounting mandatory. Inquiries we've made to local tax offices have so far not received conclusive responses.

Transfer Pricing Exposure

Theoretically speaking, ROs of overseas consulting companies and professional firms could report zero Chinese taxes if the ROs did not derive any revenue from services and assistance that they provided in China. If an RO does not earn any taxable revenue during the entire calendar year, it will, in compliance with the 2003 Circular, be required to submit an explanatory report to its governing tax office within one month after the close of the year concerned.

Representative offices are recommended to observe the Chinese transfer-pricing rules in order to develop a defensible tax filing position. China introduced its first set of transfer pricing regulations in the early 1990s.

In accordance with the aforementioned Foreign Enterprise Income Tax Law from 1991, Chinese taxpayers are obliged to observe arm's length rules in determining prices for business transactions conducted with related parties. Non-compliance may render their Chinese taxable profits subject to transfer-pricing adjustments. Chinese taxpayers are, for this purpose, defined to mean foreign-invested enterprises established in China and foreign companies that derive taxable profits from their establishments maintained in China.

"Establishments" refers to representative offices, administrative organizations, business organizations, factories, places where natural resources are exploited, places where construction, installation, assembly, exploration or other contracted projects are undertaken, and places where labour services are provided as well as business agents.

Later, the SAT issued Circular (1998) 59 in April 1998 that stipulated the detailed guidelines for strengthening and monitoring the administration of transactions between related companies. The provisions in the 1998 Circular are echoed in the PRC Administration of Tax Collection Law (Revised), issued in 2001, and the Questions Relevant to the Thorough Implementation of the«PRC Administration of Tax Collection Law»

Circular, issued in 2002. In general, the international principle of an "arm's length price" (a price at which two unrelated parties would agree to a transaction) is adopted in China's transfer pricing regime. Transactions between related companies would be scrutinized using the arm's length price benchmark.

If a tax bureau considers that any transaction is not priced at arm's length, the tax bureau is empowered to adjust the prices for tax purposes. The prescribed adjustment methods vary with the transaction nature. The methods are in line with international practices.

In general, the following methods will be used. They are the "Comparable Uncontrolled Price Method" (i.e., the market price of similar transactions between unrelated parties); the "Resale Price Method" (i.e., a reasonable profit margin based on subsequent sales price to unrelated parties); the "Cost Plus Method" (i.e., a reasonable profit on costs); and other reasonable methods such as the "Profit Split Method".

Implementation of Tax Rules by Local Tax Offices

In the past month, local tax offices in the major cities have quickly issued their own interpretation notices to implement the 2003 Circular in their jurisdictions.

The tax authorities in Beijing and Shanghai have been among the first to issue their own practice notes in response to the 2003 Circular. They categorize ROs into three types and apply different tax assessment methods accordingly.

For foreign companies engaged in the provision of consultancy services such as commercial services, legal services, taxation, accountancy and auditing, the companies are required to keep full sets of accounting books and records for their ROs for the purposes of determining the amounts of taxable revenue and taxable profits. Business tax (BT) and corporate income tax (CIT) will be assessed correspondingly.

Foreign companies in advertising, tourism and general trading and distribution should report the BT and CIT liabilities for their ROs based on the cost-plus method.

Finally, for foreign companies engaged in business activities other than the two types given above, they should report BT for their ROs based on actual revenue attributable to the activities performed by the ROs. CIT will be assessed by imputing a 10% profit ratio. Taxable services are defined to include services provided by ROs of in-house service companies to other group companies.

ROs established in Shanghai and Beijing are required to complete and report their own tax assessment evaluation forms to the tax authorities before the middle and end of August 2003, respectively.

Foreign companies with ROs in China should review their own circumstances to determine what benefits, or potentially adverse consequences, the new rules will create, and take appropriate actions in order to ensure that the new requirements will be complied with and that planning opportunities are appropriately explored.