Rep office clampdown

Keeping consistent with the new EIT law regarding Non-Resident Taxpayers

The new PRC Enterprise Income Tax Law (中华人民共和国企业所得税法)  (EIT Law) has been effective since January 1 2008. This law unifies the separate tax regimes for domestic enterprises, foreign investment enterprises and foreign enterprises, and establishes a new system and new concepts to cover a wide range of taxpayers. This meant that almost all the old tax rules governing foreign enterprises had to be amended to be consistent with the new EIT Law.

    According to the new EIT Law, taxpayers are divided into two categories: (i) Resident Taxpayers and (ii) Non-Resident Taxpayers. The Resident Taxpayer refers to a taxpayer established according to PRC law or a taxpayer established according to foreign law, but with a place of effective management located within China. The Non-Resident Taxpayer refers to an enterprise that is neither established according to PRC law nor has its management placed within China, but that does have a placement in China or derives income that is sourced from China. Following this division standard, ROs are categorised as Non-Resident Taxpayers since they have a placement in China. Hence, this means all the rules related to Non-Resident Taxpayers may apply to ROs.

    In 2009, the SAT continuously issued a series of tax regulations to fully re-establish a whole new system for Non-Resident Taxpayers. Among the series of tax regulations, the tax circular Guoshuifa [2010] No.19 entitled The Administrative Measures for the Collection of Corporate Income Tax on Non-Resident Enterprises on a Deemed Basis (Circular 19) was released simultaneously to the New Tax Rule to pave the way for the issuance of the New Tax Rule. For example, Circular 19 provides certain deemed amount methods and deemed profit rates, the equivalent of which also could be found in the New Tax Rule.

Strengthening the administration on ROs

In the past, some ROs have been found to be not fully in compliance with PRC law. For example, some ROs conduct activities exceeding their business scope, some ROs with tax-exemption status earn income from various sources which should be taxable under PRC law, and some ROs employ more representatives than is allowed or needed. The occurrence of such non-compliant acts required the laws and regulations related to ROs to be updated accordingly.

    From a tax perspective, with the trend that the new EIT Law emphasising tightening of the administration and collection on EIT, the New Tax Rule expressly provides certain articles regarding the ROs, including: (i) the procedure for registration and de-registration of ROs; (ii) the calculation methods of EIT (i.e. actual amount methods and deemed amount methods); (iii) the determination of deemed profit rate; and (iv) the application of tax-exemption status being subject to the rules applicable to the Non-Resident Taxpayers.

    From a legal perspective, the State Administration for Industry & Commerce (SAIC) issued a Notice on Further Strengthening the Registration Administration of Foreign Enterprises' Representative Offices in January 2010 to impose more stringent requirements on ROs, which includes, among other things: (i) at least a two-year existence by the foreign enterprise before the establishment of the ROs; (ii) one year terms for the registration certificate of the ROs; (iii) no more than four representatives can be hired by the ROs; (iv) the collection of funds from various sources being regarded as “Operating without a business licence”; and (v) ad-hoc spot checks by the SAIC on ROs.

An overview of the New Tax Rule

The change on the calculation method

There are usually two calculation methods for the EIT under the PRC tax regime: the actual amount method and the deemed amount method. They are different in terms of the calculation of tax basis, which is then multiplied to the EIT rate to calculate the amount of EIT payable. Under the actual amount method, the EIT's tax basis is generated from the actual profits on the accounting books of the ROs. Under the deemed amount method, the tax basis is assessed through certain methods converting the gross income or costs multiplied by the deemed profit rates. The formulas are as follows:

Under the actual amount method, the EIT is calculated as follows:

EIT=Actual taxable income × EIT rate

Under the deemed amount method, there are two calculation methods: the cost plus method and the deemed profit method.

For the cost plus method, the EIT is calculated as follows:

Deemed gross revenue = costs for the period / (1- deemed profit rate – applicable BT rate)

EIT= Deemed gross revenue × deemed profit rate × EIT rate

For the deemed profit method, the EIT is calculated as follows:

EIT= Gross revenue × deemed profit rate × EIT rate

    Under the old tax rule, the calculation methods of the EIT vary depending on the principal business of the head office of the ROs. The actual amount method is applicable to ROs providing consulting services, like auditing, legal, and tax, while the deemed amount method applies to ROs conducting trading and agent services.

    However, the New Tax Rule counts the actual amount method as primary and the deemed amount methods as secondary. First, no matter what business the head office of the ROs conduct, ROs are required to maintain accounting books and records based on official and valid vouchers. ROs must also accurately calculate their taxable turnover and profits which corresponds with the actual functions performed and the risks borne by the ROs. Secondly, for ROs which were using the deemed amount methods, if they satisfy the standards of actual amount methods (maintain accounting books and records to accurately calculate their taxable income and profits), they can apply to the tax authorities to change the calculation method from the deemed amount method to the actual amount method.

    ROs are only able to apply for the deemed amount methods if they are unable to maintain accounting books and records to accurately calculate their taxable income and profits. The cost-plus method is applicable for ROs that are able to provide accurate details of its operating expenses but cannot accurately substantiate their income or costs. The deemed profit method (based on the gross revenue) is applicable for ROs that are able to provide accurate revenue but where the costs and expenses are not clearly recorded.

The change in the deemed profit rate

The above formulas show that when applying the deemed amount methods, the deemed profit rate is used to calculate the tax basis for the EIT based on the actual revenue (for the deemed profit method based on the gross revenue) or even actual costs (for the cost-plus method). Under the old tax rule, the deemed profit rate is fixed at 10%, which in most cases is lower than ROs' actual profit rates, and therefore, ROs are preferred by foreign investors. However, according to the New Tax Rule, the rate must not be less than 15%, which means that the tax burden for the ROs has been increased substantially. The following example shows that the total tax burden has been increased by at least 24% (= (10.94%~8.82%) / 8.82%) for an RO taxed according to the cost-plus method.

    Further, Circular 19 provides different deemed profit rates for different industries: 15%~30% is applicable to construction projects, designing and consulting services; 30%~50% applies to management services; and the rates for other operating services must not be less than 15%. Moreover, Circular 19 provides that if the tax authorities have evidence to believe that the actual profit rate of a Non-Resident Taxpayer should be significantly higher than the above rates, it can use a deemed profit rate higher than the rates above in determining taxable income for that Non-Resident Taxpayer. Although Circular 19 specifically applies to Non-Resident Taxpayers and not ROs, we cannot rule out the possibility that they may be applied to ROs when tax authorities determine profit rates for the ROs.

The change in granting tax-exemption status

When it comes to granting tax-exemption status to ROs, there are always two elements which laws and regulations must expressly provide for. One is what standards enable ROs to enjoy tax-exemption preferential treatment and the other is how qualified ROs may apply for the tax-exemption status .

    In the past, the old tax rule directly lists the taxable activities and tax-exemption activities. Under the old rule, if ROs only undertake preparatory and auxiliary activities, such as gathering information on the Chinese market, providing business information and contracts on the production and sales business for their headquarters, they may be entitled to tax-exemption status.

    According to the New Tax Rule, local tax authorities will not accept applications from ROs seeking EIT exemptions and will revisit the ROs that are already approved to enjoy the tax-exemption status. It appears that all ROs will not be eligible for tax-exemption treatment from now on. In fact, as ROs are categorised under the category of Non-Resident Taxpayer, the New Tax Rule provides that ROs wishing to claim treaty treatments (i.e. tax-exemption status) will have to follow the application rules applicable to Non-Resident Taxpayers (i.e. Administrative Measures for Non-Tax Residents to Enjoy Treatments on Income under DTA (Trial), Circular Guoshuifa [2009] No.124, (Circular 124).

    As for the standards regarding tax-exemption status, whether or not the ROs may enjoy tax-exemption status depends on whether such ROs constitute Permanent Establishments (PEs) under the tax treaties. According to tax treaties, if the ROs conducting only preparatory and auxiliary activities in China do not constitute PEs, then such ROs may be qualified for tax-exemption status. Although there is no difference in this regard between the old rules and the New Tax Rule, the New Tax Rule clarifies and stresses that in granting tax-exemption to ROs, the tax treaty is the right legal basis, instead of the old rule which was issued only by the SAT.

    With respect to the application procedure, the old rules had not provided one for tax-exemption status, and the practices adopted by the Chinese local-level tax bureaus were divergent in the past regarding how ROs may claim and how local-level tax bureaus may grant the tax-exemption status. However, Circular 124 classifies income derived by treaty resident enterprises into two categories of income, which are subject to different procedures for claiming treaty treatment purposes. The Approval-application procedure is for passive income, namely dividends, interest, royalties and capital gains, while the Record-filing procedure is for active income, such as the business income of the PEs (including ROs), independent personal services, and dependent personal services. Under the Record-filing procedure, ROs are required to file the prescribed documents with the tax bureau in charge of record-filing. However, it does not mention whether there are any examination and approval procedures by the tax bureaus.

    Lastly, if ROs are treaty residents eligible for treaty treatments but had failed to apply for approval and paid excessive taxes, the RO is allowed to re-open the application for treaty treatments within three years from the date the tax was paid in order to obtain a refund.

Uncertainties arising from the New Tax Rule

Apart from the major changes above, there are certain uncertainties which may need further clarification by the SAT in the future.

Business activities subject to VAT

The New Tax Rule provides that ROs engaged in business subject to the value-added tax (VAT) must file a VAT return. According to PRC law, the VAT applies to the importation of goods, the provision of processing, repairs and replacement services, and the sales of goods.

    However, it is not likely that ROs would trigger VAT implications, the reasons for which include: (i) ROs are only allowed to import goods manufactured and sold by their headquarters for display purposes, which do not constitute the importation of goods for VAT purposes; (ii) ROs are not allowed to have equipment to provide processing, repairs and replacement services for VAT purposes; (iii) with respect to the sale of goods, ROs are not allowed to have or lease a warehouse to store the goods; instead, according to PRC law, ROs may provide a business liaison service for the sale of goods by ROs' headquarters to Chinese clients, which may trigger the business tax (BT), rather than the VAT. Hence, the reference by the New Tax Rule regarding a ROs' VAT payable business needs further clarification.

Exemption from the BT

Previously, ROs were not subject to the EIT or the BT if they only conducted market research, provided market information, established liaison and carried out other preparatory and auxiliary activities in China for the purposes of the manufacturing or selling of products from their head offices. Such ROs were eligible to apply for an exemption from EIT and BT.

    While the New Tax Rule delineates that ROs could only apply for EIT exemption if there is a relevant tax treaty or arrangement and if the ROs do not constitute PEs, and that the local tax authorities are required to refrain from accepting EIT exemption applications, the New Tax Rule does not refer to any BT exemption application. This means that even if an RO is able to obtain an exemption from the EIT, it is unclear whether an exemption from BT is also available.

Commensurate functions and risks of ROs

The New Tax Rule requires ROs to calculate the gross revenue and the taxable income which corresponds with the actual functions performed and the risks borne by the ROs. It seems that the SAT is applying Organisation for Economic Cooperation and Development (OECD) guidelines and the widely accepted international tax practice for determining the attributable profits of the PEs of the Non-Resident Taxpayer from other jurisdictions. However, the New Tax Rule describes this as a “principle,” and there are no detailed procedures as to how to conduct tests to assess whether the gross revenue and the taxable income are commensurate with the functions performed and the risks borne by the ROs. This grants discretion rights to the relevant authorities and brings more uncertainties for ROs wishing to comply with this principle.

Implications and suggestions

Current ROs: Conduct risk self-assessment

Given the New Tax Rule, all ROs are suggested to conduct a self-assessment on their tax compliance, regardless of whether or not they are enjoying tax-exemption status. For those ROs enjoying tax-exemption status, they should examine in advance whether or not there are certain activities the ROs had conducted which may have exceeded the scope of non-taxable activities, even though it is still unclear when the re-visit conducted by tax authorities in accordance with the New Tax Rule would occur. If such a case happens, the RO has to prepare to back-file the taxes incurred by the taxable activities.

    For those ROs that have already filed taxes, they also need to reassess whether their activities are within the scope of taxable events. If not, the ROs may re-open the application for treaty treatments within three years from the date the tax was paid to obtain a refund. Aside from the tax self-assessment, it is advisable for ROs to check whether any non-compliant acts under the New Tax Rule exist.

To-be-established ROs: WOFE as an alternative

ROs are not the only choice for foreign investors wishing to invest in China, especially given the issuance of the latest legislations. Compared with the previous deemed profit rate of 10% to ROs with limited functions as analysed above, the new deemed profit rate of no less than 15% may sharply increase the tax burden on ROs. Given that, a wholly-owned foreign enterprise (WOFE) may be an alternative, especially for two scenarios. The first is that if the profit rate for the to-be-established WOFE could be less than 15%, then setting up a WOFE may be more tax efficient as ROs pay more taxes when applying the higher deemed profit rate. The second is that the WOFE may enjoy certain preferential EIT rates. For example, an advanced IT service enterprise may be entitled to the 15% EIT rate, and its income derived from its offshore service may be exempt from BT. However, if such activities are conducted by ROs, the preferential tax treatments may not apply so that the tax burden on ROs is almost twice that of a WOFE.

    In the face of stricter legislations on ROs, now may be a good time for foreign investors to re-evaluate how to set up their investment strategies in China, regardless of whether the company has an RO in China or not. Taxation is always one of the crucial factors that determine investment strategy, especially if compliance costs and the development plans are taken into account as well.

John Huang, Lawrence Hu, Chris Mou, Jia Yau and Angel Wang, MWE China Law Offices, Shanghai