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By Matthew, March 18, 2010 3:49 pm

As like all of you (I imagine) I am an avid reader of Dan Harris’ writing at China Law Blog. Given that CLB is the king of legal blogs it is not necessary for me to promote it. Recently, Dan wrote a blog on the representative office problem in China. The entry is itself is solid CLB fare (interesting and on the money) and did not raise any tax issues. However, one of the comments to that entry piqued my interest. One of Dan’s reader’s commented as follows:

One of the thoughts was that not only would there be a flight to WOFE but that arrangements whereby foreign companies aren’t carrying on business in China or don’t have a permanent establishment for tax purposes will become more prevalent. On review, it may be be that foreign companies do not now require a presence in China and ‘agency’ or similar arrangements with Chinese companies may be sufficient.

I assume the first half (the non-bold part) of the paragraph was based on comments made by one of the speakers at the conference that was being referred to. I am not very comfortable with the prediction in italics. I am even less comfortable with the second part of the paragraph.

I will deal with the italics first. The problem with such an analysis is that it only looks at the Chinese tax impact of a China investment. Paying more tax in China will not necessarily translate into paying more tax overall. Most countries (well the UK, the UK and Australia at least) impose tax on residents on a worldwide basis. What that means is for companies using a RO in China and, in doing so avoiding Chinese tax, would still have been paying tax on the income from China in their home jurisdictions. The result is that avoiding tax in China may result in a company obtaining a minor or no tax benefit; yet you run a risk of penalties and interest. For this reason, I dont see the RO restrictions resulting in foreign companies not setting up in China. I would expect to see (and as I indicated in my earlier post today) a shift to alternative structures such as foreign invested partnerships.

The bold is even more problematic in that it suggests an agency relationship can remove a permanent establishment risk. It is not clear whether this was the speakers insight or the CLB readers own insight. Regardless, it is, unfortunately, not correct. A quick read of Article 5 of the EITL Implementing Regulations (a copy of the law can be found on Hwuason’s site) would destory the idea:

Where a non-resident enterprise entrusts any agent to carry out production activities or business operations within the territory of China, including the entrustment of any entity or individual to sign contracts on its behalf to handle the warehousing or delivery of goods, etc., such agent shall be regarded as an institution or establishment of the nonresident created within China.

Like any tax issue in China, the answer isnt fully decided by the domestic law but we must also look at any relevant DTA. So lets look at China’s DTA with Australia.

5. A person acting in a Contracting State on behalf of an enterprise of the other Contracting State—other than an agent of an independent status to whom paragraph applies—shall be deemed to be a permanent establishment of that enterprise in the first-mentioned State if:

(a) the person has, and habitually exercises in that State, an authority to conclude contracts on behalf of the enterprise, unless the person’s activities are limited to the purchase of goods or merchandise for the enterprise; or

(b) the person manufactures or processes in that State for the enterprise goods or merchandise belonging to the enterprise.

6. An enterprise of a Contracting State shall not be deemed to have a permanent establishment in the other Contracting State merely because it carries on business inthat other Contracting State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business. However, when the activities of such an agent are devoted wholly or almost wholly on behalf of that enterprise, it will not be considered an agent
of an independent status within the meaning of this paragraph.

Well the DTA does help a little bit, but wont assist where the agent is working exclusively for the foreign company.

A more practical point is that the agent will opbviously need to make a profit and, assuming that the price of the foreign companies products are relatively fixed, this means a reduced profit for the foreign company in the China market. It doesnt make much long term business sense to me.

A second reader then made the following comment:

If you have some sort of agency relationship in which you are doing business in China and are relying on a corporate structure to avoid taxation, then this likely will not work well, since China is also cracking down in transfer pricing taxation.

Unfortunately, I dont really agree with this one either. Transfer pricing will not be an issue in an ordinary agency relationship because the parties would not usually be regarded as related for the purposes of the transfer pricing provisions. This is obviously subject to the circumstances. Further, the transfer pricing provisions only apply where the pricing between the parties is innappropriate. There is no reason to automatically assume that this would be the case.

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By Matthew, January 29, 2010 5:25 pm

This is the first post in a series on some of the more common tax problems that I have seen in my time in working in China. A lot of these problems were, at one stage, not problems. But the changing tax environment has meant that many such arrangements are now outdated. Others were always problems, but persisted because of an environment of non-enforcement.

The following scenario is one that I have seen a lot. This relatively simple structure arose out of a lack of vigilance by the tax authorities in respect of cross-jurisdictional transactions. However, the current tax environment is markedly different from when this structure became popular. There are some aspects of this structure which are quite justifiable, meaning it wouldnt take much to make it tax compliant. The major concern with this structure is that it is unlikely to result in any major tax savings as the US corporate tax rate is higher than the Chinese rate (particularly if the company is entitled to high tech incentives).

The scenario:

Parent company is located in the US (for example) (“Parent Co”). Parent Co undertakes services for Multinational Group, a company with its head office in the US. Multinational company sets up operations in China. Parent Co sets up a WFOE to provide similar service to those operations. Multinational Group pays parent company in the US. Parent Co then “hires” the WFOE to undertake the services in China. Parent Co pays the WFOE a service fee that is sufficient to cover expenses and no more. WFOE makes no profit and pays no taxes in China. It should be noted that in most cases the client has no option but to utilise the Parent Co/WFOE structure because of the requirements set out by the Multinational Group i.e. the Multinational Group wishes to contract with the Parent Co and not via the Chinese enterprises.

This structure has been quite common in China in the past because the tax authorities did not aggressively attack off-shore income nor greatly utilise the transfer pricing provisions. There are several potential problems with this scenario in light of the current tax environment:

Transfer pricing problem: structuring a service fee between related parties so that the fee merely covers the expenses of the WFOE is not an acceptable method of transfer pricing. On a general level, service fees between related party needs to be provided at a rate comparable to the market rate for the provision of such services. The SAT has indicated early last year that it will particularly target companies that are not making profits (or are making losses) in China.

Solution: To remedy this structure from a transfer pricing perspective there is a need to impose an appropriate fee between the two companies. In practice, this can actually be quite difficult. It is important to keep extensive documentation establishing the basis on which any pricing decision is made. This includes the manner in which the business is operated. China’s transfer pricing regulations contain 5 different methods for determining the appropriate price. Which method should be used is dependent upon the various circumstances and such selection can greatly impact upon the price adopted. Transfer pricing heavily depends on comparable factors. A comparability analysis examines the functions and risk of a particular enterprise and seeks to find comparable.

Anti-avoidance problem: China’s General Anti-Avoidance Rule (GAAR) permits tax officials to make a tax adjustment where an arrangement has been entered into for the purpose of tax avoidance. The rule was only introduced as part of the 2008 changes. The GAAR has been relatively under utilised at this stage and an exception to its application is where a transaction has a reasonable business purpose. Here, the fact that the multinational company is requiring Parent Co to adopt such a structure should be provide a sufficient basis to argue that it is has a reasonable business purpose for entering into the transaction.

Solution: The best solution to this problem is to ensure that the transfer pricing is appropriate in line with point 1 above as this will likely remove any avoidance argument. Secondly, it is important to document that the transaction was entered into for commercial reasons as opposed to tax avoidance – the fact that such a structure was required by the non-related party. If these approaches are taken then the risk here if effectively eliminated.

Permanent Establishment Problem: there is a relatively small risk that the tax officials will deem the WFOE to be a permanent establishment of Parent Co in China and therefore the income of Parent Co will arguably be taxable in China. This is a very slight risk given current practices of the tax authorities in China. The fact that it is separate entity will generally, although not completely, negate the argument of a permanent establishment.

Solution: There is little that can be done to avoid such a problem other than to document that the two companies operate independently. It would be beneficial if the WFOE was doing other business in addition to what it does for Parent Co, although that would not be determinative. The risk here is very small if the transfer pricing has been done appropriately.

Business Tax: It is highly likely that no business tax is being paid on money paid between the two US companies. Presumably, business tax is paid on the services provided between Parent Co and the WFOE, although the turnover is lower than what it should be because the agreement is merely to cover the WFOE’s expenses. The problem here is that Article 7 of the Business Tax Regulations provides the tax authorities with the power to make an adjustment where taxable services are provided at significantly low prices without justifiable reasons. The authorities can also impose penalties and interest.

Solution: The problem can be resolved by adopting an appropriate transfer pricing policy in accordance with point 1. In such a case, it will be difficult for the tax authorities to argue that the price is significantly low and the risk is removed.

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By Matthew, January 4, 2010 2:14 pm

Hwuason will be holding a transfer pricing seminar on 21 January 2009 in our offices in Jianwai SOHO. This seminar will look at transfer pricing compliance after a year of the new transfer pricing rules.

A copy of the invitation is attached here.