China Releases Long Awaited Reform to IIT Law

One of the most visible impact of being recognized as a Chinese tax resident is being subject to the Common Reporting Standard (CRS), under which such an individual's financial accounts and investments in almost all major foreign jurisdictions would be collected by the competent tax authorities in those jurisdictions and shared with the Chinese tax authority, starting next September.

It is anticipated that most expats working in China would be deemed a Chinese tax resident and, in many cases, a dual tax resident of both China and his or her home country.

Generally, an applicable tax treaty would help resolve the dual residency problem for these expats. The situation is, however, more complicated with US citizens. More recently-signed bilateral tax treaties contain a tie-breaker clause that provides some specific guidelines for determining a dual resident's tax residency, but there is no such specific guidance in the US-China tax treaty which was signed in 1987. Under the US-China tax treaty, in cases of dual residency, the competent tax authorities of the US and Chinese governments will have to initiate mutual consultation process upfront to determine the ultimate tax residency of the taxpayers concerned. This process would potentially expose these dual residents to the scrutiny of both the IRS and SAT.

Hong Kong residents would also be affected. It is estimated over 400,000 Hong Kong residents currently live and work in Mainland China. Many of them are wealthy mainlanders who “emigrated” to Hong Kong years before. They have been able to enjoy the comfortable living environment of their Mainland homes while not having to pay any tax in respect of their income from sources in Mainland China and other jurisdictions than Hong Kong. For them, having their global wealth exposed in front of the SAT is certainly bad news.

Introduction of Comprehensive Income and Tax Cut

The most attractive and the most discussed feature of the reform is the tax cut. Under the proposed reform, taxpayers whose primary income is in the form of salaries would receive a generous tax cut, which would be realized through an increased standard deduction (meaning the first Rmb60,000 annual income is tax free), additional itemized deductions and modified tax brackets as summarized below.

The above tax rates are applicable to Comprehensive Income, which is another new feature introduced by the IIT reform. Comprehensive Income combines current categories of salaries and labor service income such as one-time compensation received for provision of services. Passive income from interest, rents and dividends and business income would still be subject to more nuanced rules which result in lower effective tax burden in most cases.

The current IIT Law differentiates between salaries and other labor service income, and imposes income tax on these items of income at different tax rates. Once effective, all items of income from provision of dependent and independent services will be categorized as Comprehensive Income, effectively increasing the tax burden for taxpayers who derive other forms of income from services other than salaries under the Comprehensive Income category.

Even though the entire legislation is not effective until next January, the SAT has allowed salarymen to take advantage of the new tax brackets as early as next month (October, 2018).

However, the introduction of new tax brackets and certain itemized deductions would be in conflict with the tax incentives available only to expats under lesser regulations. Many have therefore predicted that it may be the end of the long debated super national treatment of expats.

Introduction of Anti-Abuse Rules

The proposed IIT reform also introduces general anti-abuse rules, including a controlled foreign corporation rule.

The tax officials have long complained that the lack of anti-abuse rules for personal income taxation system has cost the state a fair amount of tax revenue. They also claim that Common Reporting Standard which can uncover individual taxpayers' wealth hidden overseas would be clawless without such anti-abuse rules.

Only recently, alleged abusive tax planning of some of the most famous actors and directors were exposed. This fueled wide-spread public anger. Under the current IIT law and as a practical matter, a director could start an LLC with no real assets and allow it to be taken over by a movie production company thereby turning his labor service income to be made as a director down the road into capital gains, which are subject to only a flat tax rate of 20%. Under the design of this “tax-saving” scheme, the director will continue to provide his services to this LLC after the takeover for, say, minimum wage or no pay. If the director receives the same amount of money in the form of labor services compensation, the effective tax rate would be well over 20%.

The anti-abuse rules, combined with CRS and other international anti-tax avoidance co-operations, will provide the PRC tax authorities with more ammunition in battling the increasingly aggressive and sophisticated tax planning done for high net worth individuals.

Introduction of Itemized Deductions

Last but not the least, the IIT Reform introduces itemized deductions for certain education, healthcare, family support for one's parents and housing expenditures. However, the exact deduction limits for each category and related implementation procedures remain to be seen.

The idea of such deductions is not novel and can be found in many other major jurisdictions. The million-dollar question, though, is how much revenue decrease resulting from such itemized deductions would the Chinese government be able to tolerate and how would they plan to implement and enforce such deductions.

Even though some expenses can be traced and verified through the use of VAT invoices, the money sent home to one's parents are usually in cash. It is therefore unknown how SAT plans to enforce the deductions. The purpose of having such deductions would be defeated if they cannot be fully implemented and enforced.

Allowing parents to fully deduct a child's one-to-one Rmb500/hour piano tutoring – would also be very different from allowing only a deduction of Rmb500/year for books and pencils. Thus, striking the right balance would also be a daunting task given the huge income and consumption discrepancies in China.

Also, regrettably even after the widely commented amendments become part of the IIT Law, it will continue to disallow families to file joint income tax returns. Education for children, healthcare and housing expenditures are more often borne by families as a unit. Rejecting joint tax filing would almost definitely mean that these deductions would not be as fully utilized as they should have been. Because of the one-child policy, the new generation of working parents are also the ones left facing unprecedentedly high housing prices, increased work pressure, and expensive education costs, on top of four elderly parents to look after.

Middle class families are also the ones with the greatest consumption power. A tax cut for them is no doubt good public policy, regardless of any objections by single people.

Stay Tuned

Even though the IIT Law Reform is signed into law, it cannot be implemented without SAT regulations. Many people, including professors in some of the most prestigious business schools in China expressed their concern over the fact that the IIT Law leaves the power to police the itemized deductions entirely to the SAT, which may choose to increase the taxpayers' burden of proof so as to lower SAT's own workload. It is therefore uncertain how meaningful the IIT Law Reform ultimately is for common taxpayers. However, Chinese taxpayers, analysts and other interested parties should stay tuned as to how this IIT Reform will take shape, as it may turn out to be one of the most dramatic reform measures in the past few years and hopefully the beginning of more reforms to stimulate the economy.

 David Dingfa Liu, Partner   

 Tianxiao Jin, Associate 

 FuJae Partners