Tackling Tax Controversies in China in Cross-Border Transactions

This article sets out a summary of certain controversial areas concerning the implementation of tax treaties in China, where many multinational corporations (MNCs) have encountered challenges in their cross-border transactions. It is based on the author’s more than 20 years’ practice and observation.

It specifically aims to help foreign investors when structuring and implementing their investments, operations in and exit from China, while calling for more clarity and transparency on the domestic tax legislation and implementing rules concerning tax treaty applications, as well as possible tax ruling and consultation opportunities.

While there is no perfect or universal solution to the various controversies presented, foreign taxpayers should clearly be aware of them and anticipate them in order to optimise their deal and contractual structures, to mitigate tax risks and losses through well-documented evidence and arguments, from substance to form.

Cross-border services: how is a permanent establishment determined and taxed?

Taxation of permanent establishments

In most tax treaties that China has concluded with foreign countries, a permanent establishment (PE) exists when a non-PRC tax resident enterprise (ie, a foreign enterprise) provides services through its employees or other personnel in China for at least 183 days within any 12-month period. Once such a PE is constituted, the foreign enterprise is liable to pay 25% enterprise income tax (EIT) on profit attributable to that PE, which is determined by the Chinese tax authorities using the deemed profit rate (DPR) method. The DPR applicable to PEs ranges from 15% to 50% (15–30% for technical and design services; 30–50% for management services) depending on the nature of the services rendered. The tax authorities will determine the exact DPR applicable to a PE after a review of the service contracts. Thus, the formula for calculating the EIT of a service PE is:

Total onshore (provided in China) service income x DPR x 25% EIT.

In addition, regardless of whether the foreign enterprise has a PE in China, any service income (provided in and outside of China) received by a Chinese customer will also be subject to VAT at 6%.

Practical controversies

The above PE taxation rules were set to determine how to qualify a PE and quantify the PE attributable profits. However, in practice, many tax authorities, particularly those in less developed regions, have less experience and guidance in dealing with such treaty-related applications, thus triggering various obstacles and uncertainties, like the following.

• Passport copies with China Customs entry/departures are often used to calculate the number of days expatriates dispatched for onshore services have stayed in China, to assess whether the 183-day threshold is reached. However, if all the services are rendered outside China under a service contract, the absence of any customs entry/departure record fails to justify that there is no PE, as there is no form of proof and nothing to count. This sounds rather ridiculous, but it happens.
• DPR is always assessed at the high end of the range, regardless of the facts, the industries and the service periods. For example, any services related to management will be assessed at 50% and others at 30%, which effectively further increases the tax burden on foreign enterprises.
• The tax base can always go beyond the onshore part to the total service income, despite of a split of service remuneration between services rendered in and outside of China.
• It is hard, if not impossible, to apply a taxation method on actual profit, although foreign enterprises are able to provide a complete accounting book showing an actual profit rate much lower than DPR. The usual application of DPR creates an additional tax cost for foreign contractors for their long-term turn-key service contracts in China for large-scale infrastructure projects.

Some recommendations

• To avoid generating a PE, foreign companies should plan and monitor the presence of their employees dispatched to China and try to schedule the trip more intensively, note that the work of the same group of people within the same period will not be calculated separately. For example, if a foreign enterprise dispatches five employees to work on a project in China for three days, the working time of these employees in China is treated as three days, instead of three days per person for a total of 15 days.
• Once it is anticipated that there will be a PE, foreign enterprises should let their Chinese subsidiaries employ the dispatched employees and directly invoice the Chinese client, assuming that the relevant contract allows for such a subcontracting scheme. In this case, foreign enterprises will perform the offshore part of the services, while Chinese subsidiaries will carry out the onshore part using their employed expatriates, so there will be no PE for the offshore part and onshore services will be taxed on the actual profit, not DPR.
• There should be clear splits in the service contract between onshore and offshore service remuneration, between different types of service remuneration (management and technical/engineering/consulting), and providing a description of each service that is as technical and detailed as possible, in order to avoid a discretionary application of the highest DPR on all types of services and to both onshore and offshore portions.
• For large-scale and long-term contracts, foreign contractors should try to seek tax rulings from the local tax authority for taxation on the actual profit method, rather than the DPR method, assuming that the actual profit rate is lower than DPR, which is usually the case.

Cross-border secondment of expatriates: Service PE or cost reimbursement?

Taxation on the reimbursement of the cost of expatriate employees

MNCs often dispatch executives and/or technical personnel to their Chinese subsidiaries, while suspending their offshore employment contracts and having them enter Chinese labour contracts with Chinese subsidiaries. As commonly requested by expatriate employees, the foreign MNCs continue to pay the foreign social contribution and part of the salary in a foreign currency for these dispatched expatriates, and reinvoice all these pre-paid costs to the Chinese subsidiaries, as they should be borne by the local entities. When Chinese subsidiaries reimburse the cost of expatriates invoiced by foreign MNCs, this reimbursement (ie, overseas payment) is subject to same tax filing formalities as those for a cross-border service fee payment (see section 1 – “Cross-border services: how is a permanent establishment determined and taxed?”), thus causing PE issues to arise.

In an expatriate dispatching regime, PRC tax laws set out specific criteria to determine whether a foreign company has constituted a PE in China by seconding employees to provide services to its Chinese subsidiaries, or whether it is just a reimbursement of expatriate costs pre-paid by foreign affiliates, thus not a service and no PE is involved.

The key criteria for a tax authority when assessing a service PE versus cost reimbursement is which entity has a “substantial employment relationship” with the employees. If the dispatched employees are subordinated and work for the PRC subsidiary of the foreign company, their activities will not constitute a PE of the foreign dispatching company. Consequently, any reimbursement of costs pre-paid by the foreign dispatching entity will be regarded as an internal distribution of the employees’ compensation, and will not be subject to EIT and VAT, as it is not a service by nature.

Practical controversies

The risk of a challenge on a PE created by a dispatching arrangement is often triggered when the PRC entity reimburses the secondment costs pre-paid by the foreign dispatching company. The tax authorities require the PRC entity to submit various documents for review and assessment, including the key evidence of demonstrating that:

• the PRC entity is the real employer of the seconded expatriates, through a request for secondment, the selection of expatriates, an employment contract, proof of control over the work and the assumption of the responsibilities and risk of the work performed by the employees and sole evaluation authority towards the expatriate employees;
• the PRC entity actually bears the salary expenses and related costs of the employees, that employees have paid the Chinese individual income tax on their total income and benefit, regardless of whether they are paid in or outside China, particularly the foreign social contributions; and
• the foreign company should not generate any profit by seconding the employees, the reimbursement must be made at cost without applying any margin.

However, in practice, it is very often the case that PRC entities cannot easily obtain an EIT- and VAT-exempt filing certificate for the outbound remittance of the expatriates cost, and always encounter the following challenges from local tax authorities and/or banks on the reimbursement of costs.

• The local labour contracts between the PRC entity and dispatched expatriates are always standard and simple labour contracts, which are templates used for immigration (work permit/visa) purposes, they cannot sufficiently demonstrate that the PRC entity has a “substantial employment relationship”, “control of the work” and “assumption of the risk of work” over the dispatched expatriates.
• Very few PRC entities withhold and pay the individual income tax for expatriates on their total salary and benefit package, there is usually some in-kind allowance and welfare that are not duly included into the tax base, for instance, social contributions or other commercial insurance paid in a foreign country, thus the logic between the individual income tax base and total reimbursement or package is not explainable. This gap is often understood by tax authorities that the foreign dispatching entity has generated a profit, which then implies that the “reimbursement” is a service fee payment.
• Banks, under supervision from the local foreign exchange administration, tend to be very cautious about the outbound remittance not falling under an explicit defined category, including “reimbursement”. Therefore, they either only allow recognised MNCs to do this or they limit the “reimbursement” to payments over 12 monthly periods and so qualifying as a “salary” payment, this makes the reimbursement of the costs of expatriates almost impossible.

Once these challenges arise, the authorities may deem the reimbursement as a service fee, on which the PRC entity must withhold and pay VAT and EIT on behalf of the foreign dispatching company before it can remit the payment offshore, thus creating additional tax costs of a secondment scheme. The authorities’ review process is normally time consuming and the result is not guaranteed.

Some recommendations

To avoid the potential PE risk and additional EIT and VAT costs on the cross-border reimbursement, foreign enterprises may consider having the PRC subsidiaries recruit the expatriates employees locally, or implement a regularised secondment arrangement to satisfy the employment criteria.

In a local recruitment regime, expatriate employees would receive their salaries in RMB. The PRC entities can apply to their banks to convert the RMB salaries into EUR by submitting their payroll list along with each employee passport, employment contract, work permit and individual income tax payment certificate, in the event that the expatriates need foreign currency. This of course only applies to a limited number of seconded expatriates.

In a regularised secondment regime, PRC subsidiaries are suggested to:

• carefully document the satisfaction of the employment criteria in:
1. the secondment agreement between the foreign dispatching entity and the PRC entity; and
2. the individual labour contracts between the PRC entity and seconded employees;
• timely ensure the calculation and payment of the individual income tax for expatriates to include the taxable allowance and benefits paid outside China, in order to justify the total cost paid and borne by the local employer and their IIT tax base; and
• make reimbursements periodically rather than deferring the payment for 12 months.

Indirect equity transfer: how China taxes it

Taxation of indirect equity transfer

Indirect sales of Chinese companies’ equity (ie, the sale of equities of foreign intermediate holding company – Offshore Holding – directly or indirectly holding Chinese subsidiaries) may be subject to a 10% withholding tax in China (assessed on the capital gain attributable to the Chinese subsidiary’s equity), if the Chinese tax authorities consider that neither the foreign seller nor the Offshore Holding has sufficient substance and the arrangement is an abusive use of a company structure.

Chinese tax circulars classify indirect equity transfers as:

• Green-light transactions – not subject to PRC tax, including normal trading of offshore listed shares through a public market; tax treaty exemptions and transactions qualified as intra-group reorganisation.
• Red-light transactions – a direct equity transfer subject to 10% withholding, where the following conditions are met simultaneously:
1. ≥ 75% value of Offshore Holding derived from China;
2. ≥ 90% total assets (excluding cash) or income of Offshore Holding derived from China in the year before the transfer;
3. the foreign seller and the Offshore Holding undertake limited functions and risks to support their economic substance; and
4. the foreign tax liability on the transfer of the Chinese subsidiary’s equity is less than the possible PRC tax on the direct transfer of that equity.
• Yellow-light transactions – others that cannot be classified as green-light or red-light transactions.

Whether and how China taxes yellow-light transactions is left to the comprehensive and discretionary assessment of the local tax authorities, which often triggers uncertainties and controversies in practice.

In this respect, regardless of whether the indirect equity transfer is eventually subject to PRC tax, there is a voluntary reporting scheme and a mandatory reporting scheme with PRC tax authority in charge of Chinese subsidiaries:

• Voluntary reporting – all parties (including the seller, buyer and the Chinese subsidiaries) to an offshore indirect equity transfer may voluntarily report to the Chinese tax authority in charge of the Chinese subsidiaries within 30 days of signing a share transfer agreement.
• Mandatory reporting – once Chinese tax authorities require the transaction parties to provide documents and information regarding the indirect share transfer, the reporting becomes mandatory.

Practical controversies

• When the “reasonable commercial purpose and substance” are not sufficient to assess whether a yellow-light transaction is taxable in China, the absence of a quantifiable criteria often generates conflicting opinions among tax authorities and taxpayers. For instance, some tax authorities take 20–30% equity value as a threshold (ie, more than 20–30% of the value of the Offshore Holding derives from China), while others 50%.
• Even if the transaction is deemed taxable in China, how the taxable assets attributable to Chinese business are determined is much more controversial. There is no explicit rule in this specific aspect, local tax authorities adopt various approaches and requirements; some are hard to implement, some are conflicting from one to another. Very often, Chinese local tax authorities have no clear guidance on how to value the offshore subsidiaries and deduct their value from the PRC taxable income, this may also trigger double taxation issues.
• Once the PRC taxable income is assessed, how it is allocated among different Chinese subsidiaries triggers another issue. Some local tax authorities make reference to a tax ruling the State Administration of Taxation issued to the Shenzhen tax authority, recommending the use of three weighted factors of paid-in capital, net asset value and annual turnover of each subsidiary to allocate the taxable gain. Many others believe this ruling was only addressed to the Shenzhen tax authority on a specific case and should not be generally used, particularly when the taxable income allocated to its jurisdiction is unfavourable when applying these weighted factors.
• From a reporting perspective, even if the transaction parties choose to report it voluntarily, it is hard to obtain any written assessment on the PRC taxability of the indirect equity transfer before closing the deal. It is a mere administrative filing. Some tax authorities will not issue any receipt or written reply. Even when they do issue a receipt, the document only indicates that the tax authorities have received the information submitted by the transaction party, but does not indicate any attitude or view of the tax authorities as to whether the transaction should be taxed or not. This defers the confirmative tax treatment to much later, after the closing, and may trigger a tax indemnity if the effective tax assessment differs from that anticipated by the transaction parties.

Some recommendations

The tax implications of green-light and red-light transactions are rather clear, the transaction parties just need to agree on the seller’s obligations to declare and pay the PRC taxes and provide corresponding representations and warranties (R&W) in the share purchase agreement concerning the potential tax re-assessment in the future.

However, for yellow-light transactions, the parties often hold different opinions on whether the transaction is taxable, or even notifiable, in China. In this context, from a contractual perspective:

• For the foreign buyer, it is regulated that the Chinese tax authorities may hold the buyer (as the withholding agent) liable (ie, impose a penalty of 50% to 300% of the unpaid tax) if neither party reports the transaction or pays the taxes due. In this case, the liability may be reduced or waived if the buyer voluntarily reports the transaction within 30 days of signing the transaction documents. In light of this, the buyer should always require in the share purchase agreement that the transaction will be voluntarily reported (by either the buyer or the seller) to the PRC tax authority, as this will at least exempt its potential penalty for withholding if the tax authority later claims any tax liability either from the buyer or the Chinese subsidiary post-closing.
• For the foreign seller, if its Chinese subsidiaries account for a very small portion of the total value of Offshore Holding (which is not specified by any tax rule, but “small” can be understood as less than 20%) and if the Offshore Holding has sufficient business substance, the seller should be confident that the transfer should not be subject to PRC tax. In that case, the seller may decide (and convince the buyer) not to voluntarily report the transaction to the Chinese tax authority (in order to avoid an unnecessary review and challenge). The seller should, however, be ready to make reps & warranties on PRC tax-related tax liability.

In a more general sense, when a company sets up an overseas structure, it should always consider its commercial purpose and business substance, rather than a mere PRC tax saving. In other words, an Offshore Holding should not only be used to hold equities, but should also be equipped with sufficient assets and economic functions; it should be able to generate operating revenue other than equity-based income in order to justify the business substance.

When conducting an indirect equity transfer, the group should carefully review and evaluate the whole business and identify where the core businesses are located and how the overall premium should be allocated among various subsidiaries all over the world.

• When necessary, concerning Chinese business, it is worth having a qualified third-party evaluation of its subsidiaries as if it were a direct transfer, in order to anticipate the potential capital gains to be achieved. In this regard, if the indirect equity transfer is eventually taxable in China, some tax authorities may choose to tax each individual Chinese subsidiary’s equity transfer as if it were directly transferred, thus evaluation report is generally used by tax authorities to assess the fair market transfer price.
• Some tax authorities tend to allow the foreign deductible assets to be deducted when calculating the PRC taxable income. When calculating the foreign deductible assets, it is usually necessary to provide relevant supporting documents, such as bank statements, contracts and/or registration certificates, accounting records and other information. The seller should prepare all these supporting documents to be able to justify its deduction for calculating PRC taxable income if required by the Chinese tax authority.

In cases where an indirect equity transfer involves multiple PRC tax authorities, the presiding tax authority should be selected carefully as it may impact the entire process of the case, the overall assessment of the taxability in China, the level of detail of the information to be examined, and even the calculation of the effective tax liability. The decision should be made considering various elements, including where the key PRC business and value are located, tax compliance status of the subsidiaries and their relationship with the in-charge tax authorities, the level of knowledge and experience of the relevant tax authority and the possible opportunity for a tax ruling and consultation.