Taxing Rmb funds with foreign-invested limited partnerships

According to Circular 159, regardless of whether a partnership enterprise distributes its profits to partners or not, partners should pay income tax. The taxable income of a partner shall be based on its shared percentage of the partnership income according to the partnership agreement executed by the partners.

a) EIT of a foreign enterprise (FE)

According to the PRC Enterprise Income Tax Law (中华人民共和国企业所得税法) (EITL) and its implementing rules, an enterprise or an organisation (collectively referred to as “enterprises” under the EITL) may be subject to EIT in China. According to the EITL, in order to determine EIT, a tax authority must first determine whether an enterprise is a resident enterprise (RE) or a non-resident enterprise (NRE) and whether such an enterprise has set up a permanent establishment (PE) in China.

A resident enterprise means an enterprise that is established within the territory of China or established under the law of a foreign country or region whose actual office of management is located inside China. A non-resident enterprise refers to an enterprise that is established under the law of a foreign country or region and its actual institution of management is not located within China, but that it has a PE inside China or derives incomes from sources in China even though it has no PE in China.

An RE shall pay EIT on its incomes derived both from within and outside China. For an NRE having a PE in China, it shall be subject to enterprise income tax on the PE's incomes derived from China as well as incomes derived from outside China but which have an actual connection with its permanent establishment inside the PRC. The EIT rate is a flat rate of 25%. In comparison, for an NRE having no PE in China, it shall pay EIT on its incomes derived from sources in China, such as dividends, interest, rentals and royalties. The tax rate is 10% unless specifically exempt or reduced by the PRC State Council or a bilateral treaty.

b) Foreign enterprise as the general partner of an FILP

According to the above-mentioned principal rules in connection with income tax, a foreign enterprise, acting as the general partner (GP) of an FILP, shall pay EIT at a rate of 25% if it is a resident enterprise or a non-resident enterprise with a permanent establishment within China. If it is an NRE without a PE within China, the EIT rate shall be 10%.

Generally speaking, under a partnership agreement, the GP of a FILP represents this foreign-invested limited partnership and is responsible for running the business of this FILP. It is unclear if operation activities in connection with the business of an FILP will be regarded as the GP setting up a permanent establishment within China. Chinese law does not provide a clear directive in this regard. As such, different taxation authorities may have different opinions in connection with this issue. In summary, there are currently two interpretations:

One interpretation is that the general partner itself runs the business within China. The argument is that an FILP is not an independent legal person according to Chinese law. Pursuant to the PRC Partnership Enterprises Law (中华人民共和国合伙企业法) (PEL), a GP runs the business of a foreign-invested limited partnership and represents the FILP. The Sat issued the Notice of the Sat on the Relevant Issues about the Determination of Permanent Establishments in Tax Treaties (No.35 [2006] of the Sat) and pursuant to this notice, the term “permanent establishment”, mentioned in the first paragraph of article 5 under the Chinese tax treaties, refers to a fixed place of business through which the business of an enterprise is wholly or partly carried out. Therefore, it is possible that such a general partner will be deemed as having a permanent establishment within China.

Another interpretation is when a GP runs the business of an FILP, it shall be deemed as running its own business within China. Running the business of an FILP is the reflection of its investment in and management of an FILP, therefore it shall not be deemed to have set up a PE in China. In addition, pursuant to certain taxation treaties China has concluded (for example, the China-Hong Kong Avoidance of Double Taxation Arrangement), operation by the general partner of an FILP's business is not regarded as having a PE within China.

c) FE as the limited partner of a foreign-invested limited partnership

According to the above-mentioned rules, a foreign enterprise, acting as the limited partner (LP) of an FILP, shall pay EIT at a rate of 25% if it is deemed as a resident enterprise or a non-resident enterprise, but with a PE within China. If it is a NRE without a permanent establishment within China, the EIT rate shall be 10%.

Additionally, according to the PEL of China, an LP does not have the power or right to run the business of a foreign-invested limited partnership and is not allowed to represent an FILP. General practice is that an LP only invests into a FILP and its income from it is a passive one. Therefore, a limited partnership shall not be regarded as having a PE within China just because of its investment into an FILP.

3. Individual income tax of a foreign individual (FI) as a partner of an FILP

According to the IITL, its implementation rules, and other relevant regulations and rules, for a foreign individual, regardless of his/her resident status or his/her responsibility as a general partner or limited partner in a foreign-invested limited partnership, his/her dividend income from an FILP is deemed as income originating from China, which shall be subject to IIT.

In 2001, the Sat issued the Regulation for the Imposition of IIT upon Investors in Sole Proprietorships and Partnerships (No. 84 [2001] of the Sat). According to this regulation, dividends obtained by a partnership enterprise from its investments in portfolio companies shall not be included in the income of this partnership enterprise, but shall instead be treated separately as dividends obtained by individual investors in this partnership enterprise. An individual investor shall pay IIT at a rate of 20% for obtained dividends.

Other than the investment profits from portfolio companies, an FILP may also obtain income which comes from non-investment activities such as production proceeds and other income. According to the Regulation for the Imposition of IIT upon Investors in Sole Proprietorships and Partnerships (Cai Shui [2000] No. 91), which was jointly issued by the Sat and the Mof, the post deduction of costs and expenses, and net income of an FILP from non-investments shall be deemed as the production and operation income of an individual partner. Such income is treated akin to income derived from the production and operation by sole proprietors of industry and commerce, and shall be taxed at progressive rates ranging from 5% to 35%. For instance, an income over Rmb 50,000 will be taxed at a rate of 35%.

It can be seen that the Sat and the Mof believe that the tax rate should be determined by the nature of the income obtained by an individual partner from a partnership enterprise. Whether an individual partner is a GP or LP does not affect the tax rate in connection with the income obtained from a partnership enterprise.

Xun Sun, JunZeJun Law Offices, Beijing