By Mark Schaub, Partner, Corporate, King & Wood Shanghai
See also: King & Wood's Tax Practice.
On February 20, 2010, the State Administration of Taxation (SAT) issued the “Measures for the Administration of Taxation on Representative Offices of Foreign Enterprises” (Guo Shui Fa [2010] No. 18) (the “Rep Office Tax Measures”) to reform the taxation rules applicable to representative offices of foreign enterprises in China (“Rep Office”). The Rep Office Tax Measures, which are retroactively effective from January 1, 2010, revise existing Rep Office taxation rules inter alia by abolishing previous tax exemptions and increasing the minimum deemed profit rate. Prior to effectiveness of the Rep Office Tax Measures, Rep Offices were taxed in one of three ways, (i) based on their actual profits (“Actual Profit Method”), (ii) based on their “deemed profits” (“Deemed Profit Method”) or (iii) not subject to tax (“Tax Exemption”) when certain criteria were met. The major changes brought about by the Rep Office Tax Measures include:
a) Increased Deemed Profit Rate
According to the Rep Office Tax Measures, there are only two ways to tax Rep Offices, the Actual Profit Method or the Deemed Profit Method.
The Actual Profit Method is subject to the ability of the Rep Office to properly record its operations in its financial accounting books and accurately calculate its taxable income and profit through proper reflection of the actual functions it performs and risks assumed and then report returns based on such records to the tax authorities on a quarterly basis.
The Actual Profit Method of Rep Office taxation is advantageous because, unlike the Deemed Profit Method, costs can be used to reduce taxable profits. However, if a Rep Office is unable to maintain complete accounting books, or cannot accurately calculate its returns or costs, the Rep Office will be taxed according to the Deemed Profit Method, which is based on the Rep Office’s costs or revenue. The selection will depend upon which amount can be more accurately illustrated by the Rep Office. The tax authority will designate a deemed profit rate to the Rep Office and calculate the taxable income based on such deemed profit rate.
By the Rep Office Tax Measures, the minimum deemed profit rate under the Deemed Profit Method was increased from 10 to 15 percent. It should be noted that the Rep Office Tax Measures only provide a minimum deemed profit rate so there is a chance that some local tax bureaus may decide to impose a higher rate.
b) Abolishment of Tax Exemption
The Rep Office Tax Measures repeals several previous tax regulations applicable to Rep Offices and therefore Tax Exemptions for Rep Offices have also been abolished.
In the past tax regulations previously applicable to Rep Offices include 1) regulations pertaining to a Rep Office's non-taxable activities, such as market research and information collection, 2) regulations providing for income tax exemptions for Rep Offices established by foreign governments and non-profit organizations, and 3) the specific rules relating to the classification of Rep Offices under the Actual Profit Method and Deemed Profit Method. As an alternative for the abolished tax exemptions, the Rep Office Tax Measures provide that a Rep Office at its own initiative can apply for such special tax treatment which may be applicable to the Rep Office according to tax treaties or agreements.
c) Liability for Rep Offices to pay Value-Added Tax (VAT)
The Rep Office Tax Measures also provide that, in addition to income tax and business tax, Rep Offices should also pay VAT, which generally applies to sales of goods. This new requirement is ambiguous in that Rep Offices are prohibited from directly engaging in the sale of goods.
Regarding the administrative restrictions on Rep Offices, the State Administration for Industry and Commerce (SAIC) and the Ministry of Public Security jointly issued the “Notice Concerning Further Strengthening Administration of the Registration of Foreign Enterprise Permanent Representative Entities” (the “Rep Office Administration Notice") on January 4, 2010.
By the Rep Office Administration Notice the criteria for the grant or renewal of the authorization to open a Rep Office have also been tightened. Accordingly, a foreign company which seeks to set up a Rep Office must show that the foreign company has been set up at least for two years. In the case of a renewal the applicant will need to prove that the foreign company still exists.
Further a limitation has been introduced as to the term of new and renewed Rep Office licenses for one year at a time (compared to the usual three years).
Also the number of foreign representatives in a Rep Office has been affected by the Rep Office Administration Notice. According to the new provisions a maximum of four representatives, including the chief representative, are generally allowed in a Rep Office. The transitional provision for the existing Rep Offices with more than four representatives provides that the Rep Office cannot replace employees in excess of the limit. The limit, however, does not apply to the Chinese staff employed without powers of representation.
It appears that both the Rep Office Tax Measures and the Rep Office Administration Notice have been issued to restrict and discourage the establishment and maintenance of Rep Offices. To mitigate if possible the effects of the new heavier tax burden, existing Rep Offices are advised to investigate whether the Rep Office is still eligible for tax exemption under a treaty or other arrangements. In general the new regulations may be a good reason to consider whether an existing Rep Office should be closed and that it may now be the time to consider a WFOE which may now make even more sense from operational and tax perspectives. It seems in any event that the Chinese authorities are keen to have Rep Offices revert to their initial purpose (i.e. small window offices not actual businesses). Foreign companies wishing to actually do business in China may need to consider establishing a real legal entity.
