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.

1. Was Circular 18 inconsistent with the SAIC’s Notice?
2. 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.

Hwuason Seminar Series

The End for Representative Offices?

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On 20 February 2010 the State Administration of Taxation issued Circular 18/2010 outlining a new tax treatment for representative offices (ROs) of foreign enterprises in China.

Circular 18/2010 replaces several older circulars relating to the taxation of ROs and introduces significant changes. The new circular represents a fundamental shift in tax liability for ROs in China and all foreign companies with ROs should determine how it affects them. Hwuason’s tax lawyers will outline the changes and illustrate how they will impact upon the bottom line

Issues covered will include:

1. Previous tax treatment of ROs;

2. An outline of Circular 18 and its practical implications; and

3. Moving from a RO to a corporate structure.

For those unable to attend the seminar but who would like more information in relation to this latest development, please do not hesitate to contact us.

Details:

Date: Wednesday, 21 April 2010

Time: 2pm to 3pm

Location: Hwuason Boardroom, Suite 1505, Tower B, Jianwai SOHO, No 39, East 3rd Ring Road,

Chaoyang District, Beijing

Language: English

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Hwuason is the first law firm in China specialized in taxation law. Hwuason has extensive experience in tax planning, corporate finance, foreign investment, M&A and tax related litigation.

Click here to register for the seminar.

Copyright © 2009 Hwuason Lawyers. All rights reserved. Tel: 8610-58697282      E-mail: china@chinataxlawyers.com

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.