China: Risky Business: China Issues New Rules on Permanent Establishment Risk for Foreign Business in China

Last Updated: 30 March 2011
Article by Maarten Roos and Leo Liu

Authors: Maarten Roos & Leo Liu, R&P China Lawyers

This article was written for, and first appeared in the March 2011 issue of China Law & Practice, a Euromoney publication.

Many foreign companies are unaware that their business may be subject to Chinese corporate income tax if such business creates a Permanent Establishment (PE) in China. In a recent notice, the State Administration of Taxation clarifies in great detail how PE conditions apply to a foreign company's domestic activities, and gives local tax bureau's better technical tools to identify and pursue PE's for due taxes. This initiative simultaneously serves as a reminder to all foreign businesses operating directly in China that the tax authorities are increasingly assertive about pursuing PE taxpayers. Considering the size of the potential liabilities, businesses must seriously consider PE-risk when establishing and implementing their business models in China.

PE risk is crucial to foreign companies who engage in business through people or a fixed place of business in China without establishing a Chinese-registered subsidiary or representative office. However, even businesses that do have a legal set-up in China must beware. It is not uncommon for part of the business to be done directly by the foreign entity, or for the foreign entity's managers to be sent to China to take charge of the local business; both circumstances may result in a PE for related income.

1. General Applicability

Notice 75, short for the Notice of the State Administration of Taxation on Issuing the Interpretation of the Articles of the Agreement between the Government of the People's Republic of China and the Government of the Republic of Singapore for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and the Protocol Thereof, was issued on 26 July 2010 as an interpretation of the agreements between China and Singapore on a host of taxation and fiscal issues, including PE's. However, its opening statement clearly establishes that the interpretations in Notice 75 apply not only to the China-Singapore tax treaty, but should also be referred to when considering the same concepts in tax treaties between China and other jurisdictions. Moreover, Notice 75 will prevail in case of inconsistencies between the interpretations of the China-Singapore tax treaty and previous interpretations of other tax treaties. This suggests that the notice's principles such as the definition of a PE will be generally applicable not only to individuals, companies and "other entities" from Singapore, but also those from other jurisdictions ("contracting states") with similar concepts in their double-taxation treaties with China.

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 PE's are constituted, namely based on a fixed place of business, on services, on construction work, and agency. It also provides specifics on how the secondment of expatriates to China can result in a PE.

a. Fixed Place of Business

A PE usually refers to a fixed place of business, as long as it is in physical and persistent existence (i.e. not temporarily established), and all or part of the business activities are conducted through such fixed place of business. Consider for example an unregistered office in China from which a foreign entity provides services which are then billed directly from the foreign entity.

Unlike for construction and service PE's (see below), Notice 75 does not quantify "persistent existence". It 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 bureau's 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.

b. 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 twelve-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.

c. 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. 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 PE-risk by dividing work in several separate contracts.

d. Dependent Agent

Individuals, companies and other entities can be regarded as dependent agents irrespective of whether they are themselves tax resident 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 does not conduct business activities that are not its own and 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.

e. 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 secondment 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 decided 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.

Moreover, 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 emphasizes 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. Thus even in the absence of the four elements, the parent company's substantive "control" over the secondee must be analyzed to determine whether such secondment could potentially create a PE.

Obviously, 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.


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 PE's. 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 bureau's 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, financial (fines), administrative (revocation of business licenses) and even criminal liabilities. To avoid such risks, foreign enterprises should review their organizational structure and make adjustments accordingly to either avoid PE's, or to report the PE structure to the local tax bureau and file taxes consistent with Chinese tax law.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Maarten Roos
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