Risky business in permanent establishments

2. Defining “Permanent Establishment”

The purpose of a PE is to determine whether one state has the authority to levy taxes on a tax resident of another state. If a business establishment in China is treated as a PE of a foreign enterprise, then corporate income tax will be imposed on the income from that business, usually at a deemed rate. Notice 75 clarifies how four different kinds of PEs are constituted, namely based on a fixed place of business, services, construction work, and agency. It also provides specifics on how the secondment of expatriates to China can result in a PE.

i. Fixed place of business

A PE usually refers to a fixed place of business, as long as it is in physical and persistent existence (for example, not temporarily established), and all or part of the business activities are conducted through such fixed place of business.

Unlike for construction and service PEs (see below), Notice 75 does not quantify “persistent existence”. It thus fails to resolve a controversy on what consists “persistent” (long-term) and what consists “temporary” (short-term), creating uncertainty and giving more discretion to local tax bureaus to determine whether or not the office is meant for the long-term. Notice 75 does clarify that if a place of business is initially established for temporary purposes but in fact exceeds its intended term, it will be retroactively treated as a PE. Moreover if a place of business is intended for the long-term but its operations are interrupted soon after establishment, for example in the case of an investment failure, it will still be treated as a PE.

ii. Service

Unlike for a fixed place of business PE, Notice 75 uses a fixed standard of 183 days for a service PE. This means that if an enterprise of a contracting state sends its employees or other hired staff (including Chinese staff paid by the foreign entity) to provide services in China, then it shall be regarded a service PE as long as such personnel stays in China for more than 183 days within any 12-month term.

“Service” refers to professional services of engineering, technology, management, design, training and consultancy, and specifically includes professional services for a construction project as long as the enterprise does not assume responsibility for the construction (in which case it shall meet the standards of a construction PE, see below). If the service is also provided through a fixed place of business in China, it shall still constitute a service PE as long as the service term meets the “183 days” standard.

iii. Construction

If a foreign enterprise of a contracting state establishes or supervises a construction site for more than six months, its business will constitute a PE as well. The signing date of a contract is not necessarily the starting date of the period. Notice 75 clarifies that it can start from the start of construction preparations – although this concept is not defined in further detail. The end date shall be the date of completion of the project and handover (including completion of a test run if applicable). Furthermore, if the foreign enterprise undertakes two or more consecutive projects in the same construction, the projects will together count towards the six-month period. Thus, it is not possible to avoid the PE-risk by dividing work in several separate contracts.

iv. Dependent agency

Individuals, companies and other entities can be regarded as dependent agents irrespective of whether they are themselves tax residents of China. Similar to the fixed place of business PE, there is no specific time period for PE constitution based on an agency relationship with the foreign enterprise. Instead, Notice 75 specifies the circumstances under which an agent of a foreign company is not regarded as dependent: 1) the agent is legally and financially independent from the represented enterprise; and 2) the agent conducts its own business activity only and these are not financially attributable to the represented enterprise.

This approach will make it easier for tax authorities to argue dependency, as it puts the burden on domestic entities (including individuals) to prove that they are independent and conduct activities for their own account. Consider, for example, an agent resident in China (whether an individual or a company) that signs contracts on behalf of a non-resident principal. Signing contracts not only refers to the action of “signing”, but also covers the circumstance where the agent has the authority to participate in negotiations, agree on contract terms, etc. Thus, if an agent engages in these activities and cannot show that he meets both the conditions above, then the agency can be deemed a PE for related activities, with derived income duly taxable in China.

v. Secondment arrangements

Legally speaking, a foreign-invested subsidiary is an independent legal entity whose business activities are separate from those of its foreign parent company. It should not constitute a PE merely because of the existence of this relationship. In practice however, the foreign parent company often sends its employees on secondment to its subsidiaries in China. In recent years the tax authorities have raised the possibility that such secondments could lead to a fixed place of business PE, service PE or construction PE; Notice 75 provides much-anticipated clarification.

To determine whether a secondment arrangement has the potential to create a PE, it must first be determined whether the secondee works for the subsidiary in China or for the foreign parent company. Article 5 of Notice 75 enumerates that an employee shall be deemed to be working for the parent company in any of the following circumstances:

1) The parent company has command over the work of the secondee and assumes related risks and liabilities;

2) The parent company determines the number and eligibility of the secondees;

3) The parent company bears the salaries of the secondee; and

4) The parent company obtains benefits from the subsidiary as a result of the secondment arrangement.

Notice 75 does not specify that the four elements are exhaustive. It is not clear whether a secondment will create a PE in the absence of the four elements, for example, when merely the term of the secondment is at the discretion of the parent company. However, Notice 75 does emphasise substance rather than form, and thus the primary concern of a local tax bureau should be whether the secondee works for the parent company or for the subsidiary. Even in the absence of the four elements, the parent company's substantive “control” over the secondee must be analysed to determine whether such secondment could potentially create a PE.

If the secondee is regarded as an employee of the parent company and the other conditions for PE are met, then this could have far-reaching consequences. Not only can corporate income tax be levied on secondment fees – a substantial premium on already costly expatriate salaries – but a PE could also impact individual income tax (IIT) liabilities of the said employees, as their salaries would be subject to Chinese IIT irrespective of the length of their stay in China.

3. Final thoughts

Notice 75 will broadly apply to other interpretations of prior tax treaties; in fact, this notice is expected to become the new standard for all PEs. Although Notice 75 is only a unilateral interpretation of a bilateral treaty, the Singaporean government has not responded, and so for now it will guide decisions of local tax bureaus on the tax treatment of non-resident enterprises. This means a higher level of predictability on the part of businesses, but also a larger risk to companies that fail to comply with the rules.

Often, violations of tax obligations such as failure to pay due taxes resulting from a PE are inadvertent rather than intentional. However, the state of mind of the taxpayer is not material when it comes to the serious penalties that exist on breach, with financial (fines), administrative (revocation of business licences) and even criminal liabilities. To avoid such risks, foreign enterprises should review their organisational structure and make adjustments accordingly to either avoid PEs, or to report the PE structure to the local tax bureau and file taxes consistent with Chinese tax law.

Maarten Roos and Leo Liu, R&P China Lawyers, Shanghai