Another reason why a WFOE is better than a representative office or the end of representative offices?
Okay as I mentioned, here is my analysis of Guoshuifa [2010] 18. This actually represents my second nostradamus moment during the existence of China Tax Insights. Once again, for those who had paid attention to the tax landscape in China it was not completely surprising. For the last few months I have, on several occasions, indicated that the taxation of ROs was about to change and that people should expect a change for the worse. In fact one of these posts was part of series I did on predicting big tax events for 2010 (a series I havent finished yet and probably wont before 2011 by the way Im going). Its great to already see one of my predictions – well for the ego anywhere – and in fact one of my more adventurous predictions, has come to fruition. The previous posts on this issue can be found here:
I should note that another circular issued by the SAT in February (Guoshuifa [2010] 19 is also relevant to my predictions in Are We There Yet – Part 1 and should be read in conjunction with the Circular. I will post about that other circular over the next few days.
___________________________________________________________________________________________
On 20 February 2010 the State Administration of Taxation (SAT) issued Guoshuifa [2010] 18 (the “Circular”), a circular outlining a new tax treatment for representative offices (ROs) of foreign enterprises in China. The Circular replaces several older circulars related the taxation of ROs and the changes are quite significant.
End of Tax Exemption for ROs
In the past, a large number of ROs were exempt from tax in China. The Circular now indicates that the exemption for ROs is to end – both for ROs established in the future and currently existing ROs that are tax exempt. This means a radical shift in profitability for foreign enterprises that had operated in China with such an exemption.
The Taxable Income of the RO
The Circular provides three bases on which the taxable income of a RO is determined; the actual method and two deemed methods. The actual method will apply where the RO can adequately prove gross income and expenses. A similar actual method applied in the past, but in practice it was only used with respect to professional services firms. It is not clear whether the actual method under the Circular will be similarly limited.
The two deemed methods apply where the income of the RO or the expenditure of the RO cannot be adequately established. In such, circumstances the Circular deems the taxable income of the RO to be a minimum of 15% of expenditure or gross income (whichever applies). Under the previous system, the deemed taxable income was 10% so the new Circular will lead to a higher level of taxable income for ROs using the deemed method. The fact that the deemed profit rate is a minimum amount means that local tax officials will have the discretion to impose a higher rate. Once the deemed taxable income is determined, it will then be taxed at the applicable EITL tax rate, which as indicated above will likely be 25%. As a result of all this, where minimal profit is being made by the RO, the Circular provides a strong impetus to keep accurate and sound accounting records so that the actual method can be applied.
Repeal of Guoshuifa (1996) 165
One of the more significant aspects of the Circular is that it repeals Guoshuifa (1996) 165 (“Circular 165”) without addressing matters covered in that circular. Circular 165 indicated what activities of a RO would be taxable and what activities would not be taxable. Non-taxable activities included work carried in relation to the production, manufacturing and sale of the head office’s products, market research, and liaison work. As Circular 165 has been repealed and no mention of non-taxable activities has been made in the Circular, we must assume, unless and until a further circular is issued, that all activities of ROs will be taxable in the future. We understand that tax officials have had long-held concerns about the practice ROs falsely characterising activities to fall within the exception and this may explain why these non-taxable activities are not continued in the Circular.
The Circular possibly represents a fundamental shift in tax liability for ROs in China and, as such, all ROs need to determine how it affects them and impacts upon their profitability.
Enterprise Income Tax, General China Tax
| 
representative offices, taxation of representative offices in China
Matthew
Terrific work in turning out your analysis so quickly. Good translation too.
This Circular reflects increasing concern over the activities of Representative Offices across the whole of government.
Earlier in the year, the State Admininstration of Industry and Commerce (SAIC) introduced new regulations for Rep Office establishment:
See: (Chinese) http://wzj.saic.gov.cn/pub/ShowContent.asp?CH=ZCFG&ID=329&myRandom=.36104067434913
See: (English): http://www.china-briefing.com/news/2010/01/20/new-regulations-for-establishing-representative-offices-released.html
Indeed, it appears the era of the Rep Office is over and they are no longer a useful vehicle for entry into the China market.
Now the issue is how do we shut them down and convert to WFOE’s without a major tax headache!
Chris,
Thanks very much for the positive comments. Yes the demise of ROs is something that I have been commenting on for a few months. Certainly closing one down is never easy from a tax perspective. However, sometimes you just need to bite the bullet. Problems generally dont go away in my experience.
Any praise for translations should go to my team at Hwuason. Unfortunately, my Chinese is not at that level despite the small fortune I have spent on lessons over the years.
Matthew, also useful analysis here on RO vs FICE on China Briefing, dunno if you now them: http://www.china-briefing.com/news/2010/03/05/china-ro-vs-fice.html
Thanks Alexandre. Its a nice little article but I am not completely comfortable with statements like “Most ROs are taxed on expenses”. That is not strictly correct.
Rather, both the old and new regulations deem, in certain circumstances where the actual method is not applied, the RO to have a specified profit (at least 15% under the new regs and it was generally 10% under the old) which is based upon the ROs expense or, at least according to the new regulation, income level. That deemed profit is then subject to tax at the prevailing rate (25%). The reason why lawyers have been accustomed to saying ROs are taxed at 10% of expenses is that when you take into account business tax and enterprise income tax, the tax payable is roughly 10% of the ROs expenses. Whilst the substance may be the same, it leads to confusion to simply say that ROs are taxed on expenses.
The analysis, in my view, also ignores the literal wording of the new regulation – which states that the actual method will be used unless the RO is unable to clearly account for either its income and expenses. It may be that further regulations or practice differ from this similarly with the previous regime. However, I am not prepared to assume that at this stage.
BTW nice name. Any relation to the classical musician?