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By Matthew, March 31, 2010 10:27 am

After the last few weeks I have given some thought about Circular 18 and whether I think the changes are appropriate or not. I have now decided that I am not a fan of it. Why? Because it perpetuates the notion, which is incorrect as a matter of law, that representative offices (ROs) in China have a separate legal personality. Let me explain why it does this and the problems it causes.

As most people know, ROs are not meant to be, subject to limited exceptions in respect of banks and professional service firms, utilised to carry out direct business in China. Rather, China requires foreign companies to establish a local company (a WFOE or JV) or, as of 1 March 2010, a registered partnership in order to undertake direct business here. This is no different from most jurisdictions. Australia, for example, requires foreign companies to register under the Corporations Act if they wish to carry out business.Yet, over time many ROs flagrantly breached this restrictions. More accurately I should say that many foreign enterprise utilised ROs as vehicles to undertake direct business contrary to the restrictions. This was a function of the high set-up costs for WFOEs and JVs and the requirement that such entities have a limited amount of registered capital – as an aside, I have always thought that in most cases the fear of registered capital requirements was rather strange. Who would consider establishing a business without having the necessary capital to meet initial (say first 2 years) costs? In a classic RO, the RO should never be taxable because it is really the parent company that is earning the income. The parent company should be taxed in that income – where it relates to a permanent establishment (which a RO would nearly always be) this would be at 25% and otherwise it would be at 10% as withholding tax.

However, in response to the fact that ROs were, in truth, engaging in direct business and earning income, the Chinese tax authorities sought to impose tax on them. As ROs rarely kept good accounting records (in part because they wished to avoid the perception that they were engaging in direct business and hence would not report the earning of income), the tax authorities decided to deem a ROs income based on the amount of their expenses. Expenses relating to the classic use of an RO (liaison office, marketing, promotion of goods of parent co etc) were exempt from this deeming because the RO was never intended to be taxed on such income. A lot of this was moot because a large majority of ROs actually received exempt status on all income from local tax officials are part of the policy on encouraging foreign investment in that local area – as a further aside, I have always found China’s pre-2008 tax policy fascinating and have thought that it is a great example of what the OECD refers to as “harmful tax competition”.

Circular 18, by contrast, taxes ROs on any income that is attributable to the RO – this would include income from direct business and income of the foreign parent that is attributable to the activities of the RO. Circular 18 removes both the outright exemptions and the exemption on expenses relating to the foreign parent noted above. In effect, this means that an RO will be the relevant taxpayer for the income of a non-resident enterprise and the income attributable to the RO will be taxed at 25% in accordance with the Enterprise Income Tax Law (EITL). Article 3 of Circular 18 provides as follows:

Article 3: Representative office shall apply and pay the enterprise income tax on its incomes, and apply and pay business tax and value-added tax on its taxable incomes.

Where the RO has not kept accurate accounting records, the tax authorities will again deem a profit – 15% of expenses. My problem with this is  following:

1. Strictly speaking the relevant taxpayer in respect of the income of a non-resident enterprise should be the non-resident enterprise. Now, whilst in practice imposing tax on the RO as opposed to the non-resident enterprise should not result in any difference, it is an example of expedience over legal consistency. ROs are not enterprises so should not be taxed under the EITL.
2. If the SAT wishes to utilise ROs as withholding agents for the income of the non-resident enterprise, which is understandable, then they should make this clear. This would be an approach that is legally consistent and achieves the objectives of effective tax collection. Unfortunately, Circular 18 precedes on the basis that the RO is the relevant taxpayer and is not merely a withholding agent.

Circular 18 represents a messy approach to a rather simple problem.

This is more than just a philosophical objection – a legitmate questions arises as how ROs will operate in the context of China’s double taxation agreements (DTA) and, in particular, whether they will be regarded as companies for those DTAs and, in fact, whether the DTAs should apply to ROs themselves (as opposed to the parent companies). Now, interestingly Circular 18 indicates that DTA relief will be available for ROs (see Article 10 of Circular 18). I am not confident that this is strictly correct. Let me explain why

As I usually do, I will utilise the China-Australian DTA as an example (dont worry most DTAs are pretty much the same so the points I raise here will be of general application). Article 1 of the Australia- China DTA provides that the agreement:

shall apply to persons who are residents of one or both of the Contracting States.

Article 3 then provides the following definitions:

(d) the term “person” includes an individual, a company and any other body of persons;
(e) the term “company” means any body corporate or any entity which is treated as a company or body corporate for tax purposes;

Under this definition, the question of whether an RO is a company, and hence a person, for the purposes of the DTA is dependent on whether they are treated as a company for tax purposes.  Under a strict reading of the EITL, ROs are not treated as companies for the purpose of Chine tax purposes – they do not fall within the definition of enterprise. However, Circular 18 seems to treat them as such in saying that the EITL applies to them . Can ROs then be regarded as resident companies for the purposes of China’s DTAs? Interesting dilemma and to be honest there is no easy answer. Does anyone else have any other ideas?

Despite the title of this post there is really only ugly here.

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By Matthew, March 30, 2010 10:58 pm

I have not entered into the debate over the present value of the RMB and the push by the US for it to be raised. There are many more eminently knowledgeable people than me in this area so I will leave such discussion to them. However, I came across an excellent entry at the Perspectives on Progress (POP) blog entitled “A Chinese Academics Perspective on China’s Currency“. The introduction to the post provides a good indication of its ensuing content:

In October/November of last year I worked on editing and translating chapters from a book on China’s economic reforms. The articles were written by a wide slew of Chinese academics, including one chapter co-authored by Wu Jinglian and Fan Shitao, two domestic academics (not educated abroad). They do a wonderful job of breaking down China’s currency gamble

As the title suggests, Bryan (the author of POP) then outlines the views of the two academics on this issue. Too often, I think, popular issues on China are debated from outsiders looking in. It is refreshing to read the views of insiders.

As an aside, Bryan was an intern at a previous law firm I worked at in China and he is an intelligent, thoughtful young man who has excellent Chinese language skills. I have had many discussions with him over the time that I have known him about contemporary China issues and have always appreciated his insights. He does not blog very much but when he does it is well worth reading.

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By Matthew,

In November last year I commented, in a post entitled “Bamford – special leave granted” (what an exciting title), on a significant Australian tax case  that was about to go before the High Court of Australia. The High Court today issued its decision in that case – see Bamford v FCT [2009] FCAFC 66 (3 June 2009). As I predicted in my original post, the appeals of both the Commissioner and the taxpayer were dismissed by the Court.

For those interested in tax this is a rather interesting case so I will provide a summary and explanation of the decision in the next few weeks.