Between a rock and a hard place

On July 27 2009, the Administration issued a tax notice regarding the strengthening of tax collection measures (Several Specific Measures on Further Strengthening the Administration of the Levy and Collection of Taxes (进一步加强税收征管若干具体措施)) in which the SAT says it will audit non-resident enterprises who send management personnel to China. According to a client alert issued by law firm Baker & McKenzie, part of this audit concerns establishing whether expat secondment arrangements create PE. The report is corroborated by several other specialists, including Danny Po, a partner of PricewaterhouseCoopers' tax and China business advisory services department in Hong Kong.

“We know a number of foreign-invested enterprises being challenged by their in-charge local tax bureaus regarding the potential PE created by secondees,” Po says. “Also quite a number of them received different types of survey form from the tax authorities for details of their secondment arrangement.”

Baker & McKenzie says local tax authorities hold the opinion that all secondments of expatriates to China will create a permanent establishment for the offshore employers, and the offshore employers should pay enterprise income tax on a deemed profit basis.

“Furthermore, if the offshore employers are deemed to be providing services in China, 5% business tax would also apply,” the firm continues. “This will effectively add a tax burden ranging from 10% to 15% of the payroll costs of expatriates. There is also a risk that taxes will be imposed retroactively.”

According to Jinghua Liu, a Baker & McKenzie special counsel in Beijing, the local tax authorities have been told by the SAT to assess expat arrangements. Although the Administration has not itself made a statement that all secondments constitute PE, it has delegated the decision-making to local officials. And those officials – at least in Beijing and Shanghai – now seem to be taking a very conservative approach.

“I have clients being impacted already,” says Liu. “I have a client wanting to make reimbursements to the offshore affiliate but the Beijing tax official said they now have an internal policy to treat all secondment arrangements as PE.”

The hard place
The solution may at first seem simple: give expat employees a local employment contract to cover their work in China. But this will almost certainly lead to other problems for foreign-invested enterprises (FIEs).

“China makes it very difficult to terminate anyone including the million-dollar CEO,” explains Baker & McKenzie employment lawyer and partner Andreas Lauffs. “If the new tax policy leads to … companies [having] to pay an additional 15-20% tax on expat payroll costs, the companies may have to decide between a rock and hard place.”

The metaphorical hard place is the strong employee-friendly bias of the Employment Contract Law and its implementing regulations.

US companies will probably be most concerned about putting their employees under a liberal PRC employment contract, as they are used to so-called at will employment. Under this doctrine, an employer can terminate a non-unionised employee for almost any reason at all, with no liability, as long as there is no fixed-term, express contract governing the employment relationship.

Kenny Tung, Asia-Pacific general counsel of a large US corporation, points out that giving employees a local contract is not a simple move that should be made unilaterally by the China branch of a multinational company. It can give rise to many issues, in part because foreign workers do not participate in the Chinese welfare system and could lose their home benefits.

“For those who are employed by foreign affiliates and get benefits overseas, you can't just go and sign a contract because the tax bureau came asking for one,” he says. “You need to consult with the home entity about the consequences of doing so.”

Getting a local contract in addition to a foreign contract may also give employees freedom to pursue litigation both in China and at home against the employer if anything went wrong.

“If the company went for [the Chinese contract], then come termination time the employee may be able to say: 'I do have a US contract and I may sue you under the US contract in the US, but I also want to take you to court in China'” says Lauffs. “This is rather an unhealthy position for the FIE.”

Some employers may also be put off by Article 47 of the Employment Contract Law, which dictates the amount of severance payable to employees. The sum is calculated based on the worker's years of service “at the rate of one month's wage for each full year of service”. Tung says this has not been a common issue for multinational employers.

“Only some FIEs have people who have been in China for 10 years or more – usually they've just been in China for one to five years,” he explains. “So the base for that multiplier hasn't generally been a scary number yet. Seniority of their employment in China has not been a major factor.”

Despite that, it is a fact that most expats are paid considerably more than local workers. The second part of Article 47 therefore becomes more significant: “If the monthly wage of a worker is three times greater than the average monthly wage of staff and workers in the region during the preceding year … severance pay shall be paid to him/her at the rate of three times the average monthly wage of staff and workers …”

“To the extent that the majority of expats are compensated at a higher rate [than local workers], that's a balancing provision for periods starting when the ECL took effect,” agrees Tung.

Room for manoeuvre
As with many laws and policies in mainland China, there is plenty of room for interpretation of the SAT's apparent new approach to PE, and it is not certain how far the policy reflected in the latest audits will be taken. Baker & McKenzie tax partner Brendan Kelly says that the original motive may have been to target short- and mid-term secondments, for example companies that send a technical or engineering expert to China for six months, thus providing valuable services without being localised.

“I'd view this as a just and appropriate audit by the tax authorities,” he says.

But unfortunately it seems that the Administration, or the local bureaus, may now have lost sight of this original motive and are now using the audit to scrutinise other secondments which were simply put into place for payroll convenience. This has led to considerable uncertainty among lawyers and tax practitioners.

“I'm not sure this is what they're gunning at long term,” says Kelly. “The rhetoric is a little scary at the moment. It's making everyone pause for a minute. Are they really going to hold onto this or is it just something they're talking about?”

An additional layer of uncertainty has been added by the banks that process payments for the services of the secondees. In China, banks must verify inbound or outbound foreign exchange remittances by reviewing relevant documents. Liu says that in the past the banks concerned would only require individual income tax certificates to process reimbursement payments, but now some banks are asking for enterprise income tax and business tax certificates

“It's not been uniformly enforced – different banks seem to have different practices – some are still satisfied with individual income tax certificates,” she says. “For multinational companies, when Chinese entities want to reimburse them, the first practical issue they would encounter is how the forex bank handles this.”

If the foreign exchange authority begins to require exchange certificates, then the multinationals will have to go to the tax bureau, putting the issue back in the hands of the local tax officials. According to Liu, in Beijing and Shanghai those officials do not appear willing to issue tax exemptions.

Everything's not lost
Most tax specialists agree that the SAT is generally open to comments and almost certainly appreciates the likely impact on the market if all secondments are classed as giving rise to PE. Po says his firm has approached the SAT and expressed its concern.

“We have presented our research and analysis supported by the OECD Model [Tax] Convention, [and] other jurisdictions' legislation as well as previous rulings issued by the SAT,” he says.

The OECD Model Tax Convention (drawn up in 1958 by the Organisation for Economic Co-operation and Development, of which China is not a member) includes a general definition of a PE without specific discussion on service PE. However, official commentaries on the Convention introduced an alternative paragraph on service PE, which has been used in many treaties concluded by China and its treaty partners. The July 2008 Commentary on the Convention explains that the service PE concept applies to services performed by an enterprise:

Clearly, the provision could not have the effect of deeming an enterprise to have a permanent establishment merely because services are provided to that enterprise. For example, services might be provided by an individual to his employer without that employer performing any services.

Regarding how to determine the real employer of an individual, the Commentary differentiates between the legal employer and the employer of economic substance, pointing out that, although the term “employer” is not defined in the Convention, it is “understood that the employer is the person having rights on the work produced and bearing the relative responsibility and risks”.

In cases of international hiring-out of labour, these functions are to a large extent exercised by the user. In this context, substance should prevail over form, i.e. each case should be examined to see whether the functions of employer were exercised mainly by the intermediary or by the user.

The response from the SAT to PricewaterhouseCooper's explanation appears favourable: Po says the Administration has now issued another internal notice asking the local-level tax bureaus “to hold off challenges but to collect more information from taxpayers” while it comes up with a set of clearer guidelines.

Kelly appears hopeful that the SAT will be mindful of international pressures and respond to lobbying in a positive way.

“It would be a pretty big variance from international norms on China's part if they don't accept the argument,” he says. “It will create a lot of problems if they follow through on the way described. They should be able to accept the concept of assignments that are basically the equivalent of local employment without seeing this as the provision of services – they really should get their focus right especially with the economy at this time.”

Pursuing this policy would also seem to go against the spirit of recent regulations issued by Beijing and Shanghai municipalities which are designed specifically to attract multinational companies, and include visa incentives for foreign employees. But some suggest that co-ordination between different agencies may not be adequate to prevent the promulgation of potentially damaging policies. One specialist said, on condition of anonymity, that the SAT probably does not look at how its tax policies would affect foreign direct investment.

“The sense is that the SAT people would focus more on tax law itself; it's not really up to them to consider what economic impact the enforcement of a law may give rise to,” the source said.

Watch and wait
Companies may be unsure what to do until the Administration clarifies its position. According to the specialists polled by China Law & Practice, companies should continue to ensure that their secondment arrangements are structured properly so as to make sure that it is clear the employees are working for or acting on behalf of the host entity in China rather than the home country entity.

“This can be done through properly documenting the secondment arrangement,” says Chan. “It's probably a question of fact as well.”

Companies should also think carefully before switching seconded employees to local contracts, to avoid exposure to the PRC's onerous labour rules.

The Baker & McKenzie specialists say one of the best options for multinationals may be to wait to see if the SAT issues any clarification before reimbursing the home entity for the pay of any seconded employees. In the meantime, companies should support the lobbying of the SAT.

“I'm not sure if they will issue a clarification very soon unless a lot of multinational companies start lobbying,” Liu says.