Withholding tax on consulting services

This tax regime has been harshly criticised, including by the European Union Chamber of Commerce in China (EUCCC) that has highlighted “the effect of the recent shift from a production-based to a consumption-based Vat [value-added tax] regime”. It has been criticised as this system of taxation could lead to a double taxation for the provision of services as there is no credit for business tax paid along the supply chain as there is for Vat. This has been taken into consideration in China's tax reform and hopefully the disparity in tax treatment between the commodity and service taxation policy will be remedied by the upcoming reforms. However the system for now is one where the risk of double taxation remains.

One should also note that there might be additional taxes such as river management charges. For example, the additional tax rate in Shanghai for foreign investment companies is normally 1% of the business tax. Following a new tax policy aimed at narrowing the gap between foreign-invested and domestic enterprises, foreign enterprises are no longer exempt from two surtaxes. Effective December 1 2010, foreign enterprises became subject to a construction surtax and an education surtax. The method for securing these taxes is again through a withholding tax with the enterprise's agent in China serving as the withholding agent, and where it does not have an agent in China, the assignee or buyer shall act as its withholding agent.

Therefore, the basic picture regarding enterprises providing consulting services is that they will be subject to a withholding tax at 10% for enterprise income tax and a withholding tax at 5% for business tax. Following the recent tax reforms and new surtaxes, the enterprise will be subject to a higher fiscal burden.

Many businesses are likely to wonder if the tax preference for technologically-advanced service enterprises is real, or whether or not there are any reductions or benefits that can be enjoyed now that foreign enterprises are no longer privy to wholesale preferential tax treatment.

There are still some enterprise tax reductions and exemptions that could be enjoyed. The tax required for non-tax-resident enterprises may be exempted or reduced. The enterprise tax for non-tax-residents is a preferential one and is reduced from 20% to 10%. The reduction or exemption of enterprise income tax for income from technology transfers is also of particular interest.

In fact, traditionally the Chinese government enacted quite a number of laws and regulations to encourage the import of high technology by granting tax preferences. This policy has been reiterated by China's Minister of Finance Xie Xuren in his recent article on tax reform where he expressed concern over technological knowledge and innovation. Part of the new reform is to encourage technologically-advanced service enterprises. However, the reality is that the requirements to fall within this category are quite strict and the procedure quite burdensome.

The subject must be a resident enterprise; the transfer of technology has to fall within the range regulated by the Ministry of Finance and the State Administration of Taxation; the technology transferred has to be appraised by the Science and Technology department at the provincial level or higher; the transfer of technology out of China should be identified by the department of commerce at the provincial level or higher; and then there are other further requirements set by the State tax authorities. As one can see, the tax regulations set out strict requirements for the tax preference for technology transfers and therefore it could be very difficult to benefit from this reduction.

As for possible tax reductions for business tax, business units or individuals that are engaged in technology transfer could be free of business tax altogether. These include foreign-invested enterprises, foreign-invested R&D centres, foreign enterprises and foreign individuals that are engaged in the transfer of technology, technology development business and related technology consulting, technology services business of the revenue.

Technology transfer comprises transfers of patent or non-patent technology ownership or use rights. Technology development is the development and thorough research of new technologies, new products, new processes or new materials and systems by the developer on behalf of the consignor. Technology consulting is the provision of feasibility studies, technology forecasting, specialised technical investigation, and analysis and evaluation of reports on specific technical projects.

However the same tax regulation requires an approval procedure for enjoying this tax exemption.

Taxpayers engaged in technology transfer and the technology development business, and who are applying for exemption from business tax, will need to get approval from the Science and Technology Authorities at the provincial level. Then, they will have to submit the approval together with the related technology contract and other materials to the local tax authorities for application.

While this procedure was partly cancelled by Guo Shui Han [2004] No. 825, it should be noted that this did not apply to foreign-invested companies and therefore the approval procedure is still a necessary step for foreign-invested enterprises.

The scenario analysed until now could be different if there is a Double Taxation Agreement (DTA) in place between China and the Enterprise's country. The DTA would limit China's tax authority to tax certain incomes and would permit tax credits in the resident State of the Enterprise for those taxes actually paid in China. According to the third paragraph in Article 22 of the Italy-China DTA, whatever income isn't specifically defined by the agreement is taxable by the contracting State, therefore, in the case of these tax preferences we have to refer back to China's laws and regulations and their subsequent modifications. Furthermore, to claim treaty benefits, the recent supplementary notice Guo Shui Fan [2010] No. 290 requires that the withholding agent submit record-filing. Therefore, the withholding agent's responsibility is further increased by requiring the withholding agent to submit record-filing.

After analysing the picture of the requirements and the procedure to enjoy tax breaks for income from technology transfers, it should be stressed that these preferences on tax will have to be strictly verified by the Science and Technology Department and will have to be approved by the tax authorities at or above the provincial level.

When applying for these tax exemptions, one should be prepared and have adequate supporting documents to prove the real transaction of technology-related services. One should be aware that this could cost a lot of effort and time.

Regarding withholding tax, it is mostly the state government (or the tax authorities at a suitable level) that has the right to decide the way and amount of the tax according to the national law and regulations. Again in this case, as for most tax preferences, it is the state laws and regulations that give some details of the tax collection. In any case, the assignee or buyer should always withhold the required tax or it could run the risk of being punished.

The enterprise income tax rate is normally10%, but the state tax authorities have the right to decide the actual tax rate. DTAs between China and other countries are used to avoid double taxation on the same transaction. However, the tax rate applied to a certain transaction is decided by the tax authorities and approved by different staff and officials at different levels. Therefore, the final tax rate could be different for different areas, different companies and even the same company in a different period.

Furthermore, other than tax collection on the transaction, there are also strict controls on payments to overseas companies. In this case, as required by the Enterprise Income Tax Law, the tax amount “shall be withheld by the withholding agent from the amount paid or due payable each time such amount is paid or becomes due payable”. The withholding tax should be deducted from the due payable amount to the service providers. The Chinese government tends to exercise stricter controls on overseas payments and their related withholding tax.

Since no specific tax laws or regulations support the tax benefit for provision of normal consulting services, and the approval procedure and detailed reasons for the actual tax rate are not open to the public, it is difficult for an entity to predict whether and how much more tax should be paid. One has to be wary that, in addition to the actual tax that should be paid, the tax authorities also have the right to challenge the validity of the service contract. Should this happen, a lot of further information and documents could be required, and approval of the tax rate could take a long time.

The addition of the previously exempt surtaxes, the disparity in taxation between the commodity and service industries, the extremely high burden of proof to access tax preferences for technology transfers, and the fact that the actual application still often remains uncertain clearly indicate that instead of being an improvement, the new tax reforms have only increased the tax liabilities and burdens of enterprises providing consulting services. Enterprises providing consulting services are still penalised by this continued uncertainty of tax imposition, the present persistent risk of double taxation and now a higher tax liability.

Giovanni Pisacane, Lea Murphy and Angela Fiorella, Greatway Advisory, Shanghai