Foreign enterprises often come across a baffling issue when providing technical or consulting services by dispatching employees to its Chinese partners or affiliates. They are mandated to pay enterprise income tax in China even though they establish no physical office there. This practice triggers great concerns about double taxation. Moreover, a foreign enterprise must settle all tax matters properly either by requesting its Chinese partner to do so or by finding an agency to do it before receiving payments from China. It is a time-consuming process that makes it difficult to forecast cash flow. This blog provides guidance and adds clarity to your Chinese business activities by identifying and discussing the legal issues related to the levy of enterprise income tax on a foreign enterprise with no physical establishment in China.
Looking to the UN model for guidance
A guiding principle of the income tax laws in China is that all the income, regardless whether it is earned by residents or non-residents, generated within the Chinese territory shall be subject to income tax unless otherwise exempted through special legislation or tax treaties ratified by the central government. The Chinese government adopts the UN model in negotiating bilateral tax treaties with other industrialized countries or regions.
Contrary to the model adopted by the Organisation for Economic Co-operation and Development and favored by many industrialized countries, the UN model honors a source country's taxing rights over the business income of non-residents. According to the UN model, a source country may tax the profits of a contracting country (residence country) enterprise provided it carries on business through a permanent establishment situated within the source country.
The term "permanent establishment" under the UN model is defined as follows:
[T]he furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only if activities of that nature continue within a Contracting State for a period or periods aggregating more than 183 days in any 12 months commencing or ending in the fiscal year concerned."
This expanded definition does not exist in the OECD model.
Method used for bilateral treaties negotiated by the Chinese government
Bilateral tax treaties executed by the Chinese government incorporate language similar to the UN model. For example, the 1984 tax treaty between China and the United States uses almost the same definition for a "permanent establishment" where the activities of furnishing services continue for the same or a connected project. Thus, to furnish services for the same or a connected project in the mainland for more than 6 months in any 12-month period will constitute a permanent establishment and subject the enterprise to taxation by the Chinese government on profits it earns.
When calculating the period of furnishing services for identifying a "permanent establishment," the presence of employees or other personnel in China shall be treated as continuous. Thus, even if employees or other personnel of a non-resident enterprise come and go, they are counted as having been in China for more than 6 months during the preceding 12-month period, and the enterprise shall be deemed to be a permanent establishment.
25% unified tax rate
A unified tax rate of 25% applies to the income of all residents and also to non-residents with establishments in China. If non-resident enterprises have not set up establishments in China or have set up establishments earning income unrelated to those establishments, they will enjoy a lower tax rate of 10% on income originating from the mainland.
According to the provisions of 2010 Administrative Measures for the Assessment and Collection of Income Tax against Non-resident Enterprises, if a non-resident enterprise with an establishment in China cannot accurately calculate and declare its taxable income, the tax authority may assess its taxable income based on its total revenue and a profit ratio assessed by the tax authority. The tax authority determines the profit ratio of non-resident enterprises based on the following standards:
(1) The profit ratio for enterprises engaging in contracted engineering, design or labor consultation services shall be from 15% to 30%.
(2) The profit ratio for enterprises engaging in management services shall be from 30% to 50%.
(3) The profit ratio for enterprises engaging in other labor services or operations other than labor services shall be no less than 15%.
In taxing practice, income originating from consulting services, is assessed at 20%. Furthermore, the tax authority may designate the Chinese payer as the withholding agent if the non-resident enterprise does not complete the required tax registration or entrust a representative to perform its tax payment obligations in China.
Other tax liabilities
Apart from the enterprise income tax, non-resident enterprises will also be subject to other categories of taxes when providing services in China. Those taxes include:
- Value-added tax
- Urban maintenance and construction tax
- Education surcharges
- Stamp tax.
All entities and individuals selling products and services in China shall pay value-added tax. All the taxpayers of VAT, business tax, and consumption taxes must also pay urban maintenance and construction tax and education surcharge calculated on top of the foregoing taxes paid by the taxpayers.
Entities and individuals who execute or receive contracts for purchases and sales, processing, contracting of construction projects, property leasing, cargo transportation, warehousing storage, loans, property insurance, or technology within the territory of the PRC will be levied with a stamp tax. Enterprises may also be levied with local taxes for selling products or providing services in a certain region, such as regional education surcharges and regional water conservancy construction funds. Thus, adding up all the potential taxes for furnishing services by a foreign enterprise identified as a permanent establishment in China, the tax burden would amount to more than 10% of its total revenue.
Foreign companies considering dispatching staff or other personnel to provide services in the PRC need to have a clear understanding of the applicable rules and regulations that may apply to them. For example, in order to avoid needless taxation, you need to have strict control over how long personnel remain in mainland China to avoid losing any exemption granted by a tax treaty.
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.