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By Matthew, February 5, 2010 11:24 am

In China, past lenient tax practices resulted in the development of poor tax practices. One in particular has been the practice of splitting employees salaries into two components (on-shore and off-shore) with only one being reported (the on-shore component) to the tax authorities in China. Where the employee was a foreign expatriate, depending upon the tax laws of that employee’s home country, this could result in a significantly lower overall tax burden for that employee. It was also not uncommon, and still is not uncommon, for local employees to have a portion of their salary paid off-shore, usually in a Hong Kong bank account. Using this method, employers could get away with paying an amount below what the market demanded because the employees’ after tax income would still be comparable with the after tax income they would have received had the employer paid them gross  salary commensurate with the market value and not used such an arrangement.

The problems with such a strategy

In China’s tough new tax environment such arrangements as described above carry with them significantly increased risk, for both employers and employees, than previously. Despite once being relatively pervasive, such an arrangement is not a legitimate form of tax planning – it is tax avoidance pure and simple. At the very least, all employees should be aware of this and be provided with a sufficient understanding of the risks that they bear by accepting it. As the saying goes, ignorance of the law is no excuse. This is particularly an issue if the relevant employment contract, as nearly all contracts with respect to such arrangements do, contains a clause indicating that appropriate payment of taxation liabilities is the responsibility of the employee. Such clauses will make it difficult to raise an ignorance argument by the employee if the arrangement is later subject to investigation by the authorities. From the employer’s perspective, such clauses provide absolutely no protection and are effectively pointless. Employers, as withholding agents, have an obligation to withhold and remit tax to the tax authorities in accordance with Article 5 of the Provisional Measures on Withholding Individual Income Tax. A clause in an employment contract cannot alter this legal requirement.

Solution

Smart employers should adopt a remuneration strategy that complies with current tax regulations and also maximizes the organization’s overall recruitment goals. Competitive packages can be assembled that meet the overriding objective of reducing costs and that do not rely on the crude arrangements outlined above. When formulating a remuneration strategy, particularly in respect of localized foreign expatriates, employers should look at the overall cost of employment and work with the employees strike a balance between cash and non-cash benefits. China’s individual income tax regime provides various opportunities for flexible remuneration strategies.

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By Matthew, January 27, 2010 11:01 am

China will impose a 20 percent tax on income from the sale of restricted shares, effective Jan. 1, the official Xinhua news agency reported on Thursday, in a move that could offer stability to the stock market.

Income from the sale of ordinary shares, including those in public offerings and secondary trading, would continue to be exempt from taxation, it added.

http://business.asiaone.com/Business/News/My%2BMoney/Story/A1Story20091231-189121.html

I didnt mention this news when it was first released primarily because it is not a significant issue that affects my particular practice and, to be honest, it is really not that newsworthy once you look at the issue properly. However, I have heard an amusing tale behind the policy change that I thought I would share. Also, a lot of the news on this issue has not been very clear, and in some cases somewhat misleading, so I thought I would try and to clarify the issue. For example, from the same article as above it is stated:

China has not taxed income from share sales by individuals since 1994 as it has sought to encourage the development of its capital market, Xinhua said.

This suggests that the exemption for tax applies to the sale of all shares by individuals in China when in reality the exemption is limited to shares listed on the stock exchange (Caishui [1998] 61). Secondly, the exemption has never applied in respect of income from employee stock options (either through the accretion in value derived or through tranfser of the shares) as such income is considered to be related to employment and therefore is characterised as employment income (for example, see Guoshuihan [2009] 461). This is actually very important to note, because this is when restricted shares are primarily used. In other words, restricted shares have, in many cases, not been exempt from tax in China.

A colleague of mine had an interesting story of why he thinks this exemption has been lifted. This story is  one that can only happen in China.

As China has developed over the past 15 years one of the problems faced has been the acquisition of land for development. As a lot of the land in the outlying was effectively “owned” by farmers. The cost of paying market rate for such land would have added a very significant capital burden for the developments. Accordingly, rather than pay the farmers money for this land, it was decided to grant them shares in publicly listed real estate holding companies. The government forced the farmers to accept this deal. The shares were restricted so that they could not be sold. At the time these shares were effectively worthless and accordingly there was a lot of anger over this issue. However, in 2008 the government removed the restrictions on the sale of these shares and overnight they became extremely valuable. Many of these farmers are now very wealthy. Obviously, many of them decided to cash in on their shares. The problem for the government was that the transfer of the shares would have been tax free under the exemption – hence the reasoning behind the new circular.

Interesting story. Is it the true explanation of the reasoning behind the change? I have no idea.

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By Matthew, January 4, 2010 11:54 am

Much of my practice at Hwuason involves advising clients on the interaction between China’s tax laws and the tax laws of another country. It has often been said that international taxation is one of the few truly international areas of the law. As such, a China tax professional advising on the tax implications of cross-border transactions must be aware of more than just China’s tax laws

In this light, a few months ago I wrote about the effective end of the 23AG exemption for Australian tax residents in respect of foreign earned income. Since then I have had a number of inquiries about this issue. As such, a full explanation of the impact of the ending of the exemption and the taxation of Australian tax residents on China sourced income is timely. This post will be mostly relevant to Australians working in China, but it will discuss issues of China individual income tax that can be applied generally.

Liable to Taxation in Australia

If you are an Australian tax resident your assessable income includes your ordinary and statutory income derived directly or indirectly from all sources whether in or out of Australia; that is, you are taxable on your worldwide income. If you are not an Australian resident, then you will only be liable to taxation in respect of Australian sourced income. Accordingly, in respect of China earned income the potential for double taxation only arises if the person is an Australian tax resident.

The tests for residency for individuals are found in section 6(1) of the Income Tax Assessment Act 1936 (Cth). The first point to make clear, and what many people often do not understand, the question of resident for tax purposes in Australia has no connection to whether that person is a resident or citizen for immigration purposes.

The primary starting point is that a person is a resident of Australia if they “reside” in Australia (this is referred to as the “ordinary concepts” test). The word “reside” is considered to mean “to dwell permanently, or for a considerable time, to have one’s settled or usual abode, to live in or at a particular place” (Levene v IR Commrs (1928) 13 TC 486). This primary position is then expanded by three statutory tests:

1. Where the taxpayers domicile is in Australia, unless they cease to reside in Australian and the Commissioner of Taxation considers the taxpayers permanent abode is outside of Australia;
2. Where the taxpayer has been physically in Australia for more than one-half of the income tax year (i.e more than 183 days);
3. Where the taxpayer is a contributing member the superannuation fund for Commonwealth government officers.

It is not within the scope of this posting to provide an in-depth explanation of these statutory tests. However, two critical points should be made. Firstly, all individuals have what is referred to as a domicile of origin (this will usually be the country of their father’s permanent home). The domicile of origin can be replaced by a domicile of choice but the important aspect of this is that is extremely difficult alter your domicile. Accordingly, in most cases a person’s domicile will never change, even if they live outside of Australia for more than five years. Secondly, as the a person’s domicile is unlikely to change, the question of residency is usually determined by whether that person’s permanent place of abode is outside of Australia. This test depends upon various factual circumstances but the Commissioner’s general practice is to require the person to live overseas for a two year period. It should be noted that it is highly doubtful that such a position has any basis in law. Other factors that the Commissioner will consider for this test include:

1. Intended and actual length of the assignment.
2. The duration and continuity of the presence in the overseas country.
3. Establishment of a home outside Australia.
4. Whether the family accompanies the individual to the host country.
5. Whether the place of residence in Australia has been abandoned whilst overseas.
6. The durability of association that the individual has with a particular place.
7. Keeping bank accounts in Australia.
8. The sale of Australian assets, such as a car or house, prior to departure.
9. The place of education of children.

It should be noted that this position can be altered for the purpose of a double tax agreement. Under the China-Australian double tax agreement there is a mechanism, where a person is resident of both countries, for determining the appropriate country of residence for the purpose of the agreement. However, to be a resident for China tax purposes there is effectively a new to have resident in China for 5 continuous years. Accordingly, such an issue will generally never arise – because Australian tax law would generally treat a person as a non-resident after two years.

Section 23AG

If you are non-resident for tax purposes, then no liability for taxation will arise in Australia in respect of income earned from employment in China. However, if you are an Australian tax resident then your China employment income will, ostensibly, be subject to tax in Australia. This was where section 23AG previously became operable.  Until 30 June 2009 section 23AG provided an exemption from Australian tax for foreign employment income provided certain conditions were satisfied.

However, since 30 June 3009 the section 23AG exemption has been limited to income in respect of the following activities:

1. The delivery of Australia’s overseas aid program by the individual’s employer.
2. The activities of the individual’s employer in operating a developing country relief fund or a public disaster relief fund.
3. The activities of the individual’s employer being a prescribed institution that is exempt from Australian income tax.
4. The individual’s deployment outside Australia by an Australian government (or an authority thereof) as a member of a disciplined force.
5. An activity of a kind specified in the regulations.

There were some good policy reasons for removing the 23AG exemption. Many taxpayers who were working short term secondments overseas were being paid in Australia and such income was not being taxed in the country in which they were working. Accordingly, such persons were generally receiving tax free income.

Post-23AG

In the post 23AG environment there are two ways in which an Australian tax resident can avoid double taxation in respect of foreign employment income; the foreign income tax offset provided under Division 770 of the Income Tax Assessment Act 1997 or if a relevant double tax agreement provides relief.

Working in China

All persons working in China will generally be subject to tax on their China employment income. The exception to this is where they reside in China for less than 90 days, or pursuant to the China-Australian double tax agreement in respect of Australian tax residents, less than 183 days. Accordingly, Australians working in China on short terms secondments of less than 6 months will not be liable to tax in China and accordingly no issue of double taxation will arise.

However, in respect of Australians working in China for periods between 6 months to 2 years, there is a potential for double taxation. This double taxation is basically avoided by the foreign income tax offset mentioned above. One problem with relying on the foreign income tax offset is that the taxpayer must make an application for such relief, including providing proof of tax paid overseas. Such proof is not always easy to obtain in practice, particularly in respect of non-english speaking backgrounds. One issue that can arise in such environments is that the respective employer may not, without the employee’s knowledge, in fact have been paying tax in respect of the employee.