There are a lot of myths and misunderstandings about representative offices … probably the biggest is the idea that there is a 10% tax on the gross expenses of ROs. I pointed out previously (see my response to Alexandre in the comments section) why such a statement is strictly incorrect and is unhelpful in terms of comparing the relative tax merits of an RO as opposed to other investment forms.
The reason I bring this up is that yesterday I presented in Hwuason offices a seminar on the tax changes for ROs (a copy of the presentation can be found here). In preparing for the seminar I reviewed – as I often do – other professionals’ views to see whether they had any insights or ideas that I had not considered. A recurring theme in quite a few of the materials I came across was that there is an inconsistency between the SAT’s treatment of ROs (in Circular 18) and the treatment of them by the State Administration for Industry and Commerce (SAIC). The SAIC reconfirmed in January – in the Notice on Further Administration of Registration of Foreign Companies’ Resident Representative Offices (see more here) – that ROs could not undertake direct business in China. The SAT’s alleged inconsistency is that it indicates ROs may be taxable on actual income. The question is, according to some views, how can a RO have actual income if it cannot undertake direct business? Here are some of views I read:
From Mazars Hong Kong:
However, the tax filing on “actual basis” poses legal dilemma to ROs. In general, ROs are not allowed to conduct revenue generating activities in China. Circular 18 now requires ROs to ascertain their revenue by reference to their functions and risks, which seems to be contradictory to the capacity of ROs. There will be inconsistency in ascertaining the legal and tax position of ROs.
From Salans:
The inconsistency also theoretically exists between the tax rules and other rules issued by the Chinese government. According to Administration Rules on Permanent Representative Offices of Foreign Enterprises (“SAIC Rules”) issued by the State Administration of Industry and Commerce (“SAIC”) in 1983, a Rep office cannot directly engage in business operations
This may create a theoretical challenge if tax authorities are entitled to tax the income of a Rep Office from business operations, while such income may be illegal under SAIC Rules.
From Guo Lian Law Firm (I had actually never heard of this firm before – which is probably my ignorance – but am impressed with their analysis in this article):
Although the Provisional Measures permit all Rep Offices to apply the Actual Taxable Income Method in calculating the CIT, it shall carry no implications of lifting the long-standing ban on Rep Offices from engaging in direct income-generating business activities in China. We believe that Rep Offices shall remain away from any the activities.
Accordingly, at the seminar I posed two questions.
- Was Circular 18 inconsistent with the SAIC’s Notice?
- Does Circular 18 provide tacit approval for ROs to engage in direct business?
My answer to both these questions was NO.
The reason is that Article 3 of Circular 18 states as follows:
Representative office shall apply and pay the enterprise income tax on its attributable income.
The term “attributable income” has a very specific meaning in international tax – it is commonly used in terms of taxing companies in respect of “permanent establishments” they have in a foreign country. Income could be attributable to a source (such as an RO) without that source actually directly earning the income. In other words, the parent company of an RO will often earn income that could be attributable to the RO without the RO engaging in direct business. This is actually the classic model of an RO. In such circumstances, Circular 18 is saying that China will tax the RO on that income and in order for the foreign investor to avoid either of the two deemed methods, accurate accounting records need to be maintained to reflect what income is attributable to the RO.
Even if this view is incorrect, which it is not, I would still answer no to the second question. The SAT has no legal authority to indicate what business activities are lawful for an RO to operate. At the same time, the SAT will treat legal and illegal income equally – it will tax them. A drug dealer cannot resist tax on the basis that his/her income derives from the proceeds of a criminal act. Such an argument that the “inconsistency” between Circular 18 and the SAIC Notice requires clarification is, with the absolute respect, bunk.
As an aside, I was very happy with how the seminar went and I am looking forward to doing the next seminar in May (probably on partnerships – stay tuned).
UPDATE 26/4/2010: I would have done this as a separate post but I promised no more posts on ROs. We are already beginning to see the interpretation of the new rules by the local tax authorities. In early April the Shajing Local Taxation Office in Shenzhen province re-assessed 15 ROs and increased the payable tax by almost RMB700,000. As part of the new tax environment for ROs, the Shajing Local Tax Office examined these ROs and discovered that the ROs had only paid their income tax to the state tax bureau but had not met their taxation obligations with the local tax bureau. The chief representatives of the RO were required, as part of these investigations to have discussions with the local tax officials in relation to the nature of their business.
The tax officials also examined and compared the materials provided by the ROs. As part of this process, the ROs indicated that there were some ambiguous aspects to the new policies. As transitional concessional arrangement, the local tax officials provide some guidance on the new policy to the ROs. However, it cannot be expected that the officials will take such a conciliatory approach in the future.
I will try and report any practice developments I come across.
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