US companies often send headquarters personnel to assist the start-up and development of Chinese affiliates, and later to supervise and manage them in their growth. These personnel often spend some or all of their time in China for a given period, and travel back and forth. Who is the employer of these traveling personnel – headquarters? The Chinese affiliate? Both? This issue raises important tax questions. Both the US and China want their fair share of individual and enterprise tax from such individuals’ presence and work.

 

One commonly used device is secondment. Under a secondment arrangement, headquarters send an HQ employee to the Chinese affiliate to assist in a specific area – for example, financial controls, marketing, quality control, manufacturing processes. The employee remains fully on HQ’s payroll and benefits plans. The affiliate pays HQ to reimburse it for the costs of at least a pro rata amount of the employee’s time devoted to China. The secondment arrangement aims to keep a single payroll for the employee. But in this example, if the employee spends most or all of the time in China doing what a Chinese employee would otherwise be doing, the Chinese tax authorities face the loss of taxable revenues from non-receipt of taxes on the employee as well as from the deduction the Chinese affiliate takes against its income when it pays HQ in reimbursement. The problem is particularly acute when a US company has no Chinese affiliate and simply sends its personnel to China without intending to create a taxable permanent establishment within China.

 

Circular 19 issued by the PRC’s State Administration of Taxation (SAT) in February 2010 has a major impact on secondment arrangements and may effectively end their use in China. Circular 19 requires non-Chinese businesses to keep precise records of services performed inside and outside of China by employees that have a Chinese connection. Company records must allow local Chinese tax authorities to determine the foreign entity’s Chinese taxable income on the basis of deemed profits. Consider, e.g., a US architectural firm that lands a large contract to design development of a mixed-use center in Chongqing. Much of the design work will be done in the US by people who never travel to China. But some will be done by the firm’s people in Chongqing as they travel there for planning sessions or during construction oversight. If the US firm fails to establish a Chinese entity, it runs the risk that the Chinese authorities will deem one to have been permanently established, and then taxing it as such (plus potential penalties). Both Chinese Government rules and the US/China Double Taxation Treaty provide the rules that determine whether a permanent establishment is created by the presence of personnel in China. Assuming a Chinese presence has been established, Circular 19 allow Chongqing tax authorities (1 of China’s few self-governing cities) to tax the US firm on a deemed profit rate basis. The percentages that may be assessed on gross income from the Chinese engagement can range to more than 40%. So, for the architectural firm in this example, it can be forced to pay substantial tax set by local Chinese authorities for “onshore income.” Without business records that substantiate the actual amount of this Chinese based income, the Chinese authorities are free to make their own determination and declare that all service income from within and outside of China is the base figure against which Chinese tax will be assessed.

 

For businesses with a Chinese affiliate, secondment is no longer a good solution, as it effectively creates no documented allocation other than an invoice from headquarters to an affiliate. What to do?

 

An alternative is dual employment. This would entail two employment contracts for the same person – one with HQ and the other with the Chinese affiliate. Each contract would specify the amount of time and services the employee would provide specifically to each employer. With a fair allocation of time, responsibility and compensation by each company, combining into an acceptable overall package for the employee, the dual employment scenario provides for separate documented pay packages. This allows the Chinese authorities to apply individual income tax (IIT) on compensation for work done and paid for within the Chinese affiliate, and to justify an exemption from Chinese IIT on work done outside of China. The Chinese employment agreement would detail the distinct responsibilities and compensation for Chinese sourced time and effort. And the part of the employee’s time spent outside of China should not be paid by the Chinese affiliate, except for properly charged administrative services in which the employee is acting on behalf of headquarters for the benefit of the Chinese affiliate.