Nonresident enterprises are subject to Chinese enterprise income tax (“EIT”) on income derived from international transportation business in China. The State Administration of Taxation (“SAT”) has specifically promulgated various regulations and rules in this area since 1993. To streamline the regulations and rules, the SAT recently released Announcement [2014] No. 37 (“Announcement 37”) with respect to taxation of international transportation business by nonresident enterprises. Announcement 37 takes effect on August 1 2014 and currently applies to EIT only. Its potential application to business tax in the context of an applicable double taxation agreement (“DTA”) is lost due to the VAT reform.

Sourcing Rule

Under Announcement 37, the term “international transportation business” refers to (i) business activities conducted  by nonresident  enterprises with respect  to the transportation of passengers, cargos, and mails etc., in and out of Chinese ports, via owned or rented vessels, aircrafts, or shipping spaces as well as (ii) certain supplemental activities such as handling and warehousing. The definition covers both outward and inward transportation services, beyond the previous scope of outward transportation services only as set by Guoshuihan [2008] No. 952 (“Circular 952”).   Circular 952 is now replaced by Announcement 37.

Active Business Income

Announcement 37 is seeking to tax active business income only, thus excluding passive income. Such active business income partially consists of  operational income derived from voyage charter, time charter, and wet lease of vessels or aircrafts by nonresident enterprise. On the other hand, it expressly excludes rental income arising from bareboat charter and dry lease of vessels or aircrafts, or lease of containers or other shipping vehicles.  The default rule is that active business income of nonresident enterprises is subject to a 25% EIT on profits, while passive income pays a 10% withholding tax on the gross amount.   Thus, nonresident enterprises normally pay a 25% EIT on income of international transportation business.

Deemed Profit Rate

Nonresident enterprises are generally required to calculate income from international transportation business based on accurate and complete accounting books and records. As long as these book-keeping requirements are met, the actual income method will apply. Otherwise, nonresident enterprises are taxed on a deemed income basis. Announcement 37 mandates a minimum 15% deemed profit rate as specified by Guoshuihan [2010] No. 19, which triples the previously prevailing rate of 5% as laid out in Circular 952. In other words, the potential tax liabilities could increase significantly.

Application of the DTAs

Nonresident enterprises are exempt from EIT on income of international transportation business, to the extent that their home jurisdictions have entered into a DTA with China entailing such benefits. To claim the DTA benefits, nonresident enterprises are required to make a filing with the in-charge tax bureaus for recording purposes. The filing needs to include various documents, include (i) home jurisdiction business registration certificate, (ii) home jurisdiction resident certificate, (iii) international transportation business contracts, (iv) written statement on transportation routes, contents, and stops in Chinese territory, and (iv) other materials as required. Once accepted, the filing will remain good for three years. The EIT exemption offered by the DTAs will certainly place nonresident enterprises from jurisdictions elsewhere in a tax disadvantageous position.

Designation of Withholding Agents

Nonresident enterprises generally pay tax on their own or through authorized agents (not withholding agents) in regard to income of international transportation business. In some circumstances (such as failure to make a tax registration or file a tax return by nonresident enterprises), however, the in-charge tax bureaus will specifically designate certain domestic payers as a withholding agent for nonresident enterprises involved. The withholding agents include (i) entity or individual payers who remit payment to nonresident enterprises, their domestic subsidiaries, branches, representative offices, or foreign or domestic authorized agents; (ii) entity or individual payers who remit payment through foreign related parties or special interest third parties; and (iii) other entities or individuals as required.  The objective is clearly to strengthen the tax enforcement beyond voluntary compliance of nonresident enterprises by tying up with these withholding agents.

Our Observations

Announcement 37 is not a simple consolidation of the preexisting regulations and rules. Instead, it will substantially strengthen the administration of taxation on nonresident enterprises engaged in international transportation business in multiple ways. Both outward and inward transportation services become relevant in this context. The deemed profit rate is raised to a minimum 15%. Exempt nonresident enterprises must file to claim the DTA benefits. Non-exempt nonresident enterprises could be assigned certain withholding agents to help the in-charge  tax  bureaus. Obviously, nonresident enterprises and their withholding agents have to be prepared for this new enforcement landscape.