On December 23, 2008, the Ministry of Finance (MOF) and the State Administration of Taxation (SAT) jointly issued the Circular on Issues Concerning Income Tax of Partners in Partnership Enterprises (Caishui  No. 159, Circular 159) to address the unified tax treatment of partnership enterprises.
Circular 159 confirms Article 6 of the Partnership Enterprise Law of the PRC, which provides that partnership enterprises are entitled to pass-through tax treatment. In other words, partnership enterprises are not obligated to pay tax on their income. Rather, the partners to such enterprises, regardless of whether they are natural persons or legal persons (incorporated entities), are liable for tax in their separate and individual capacities. Specifically, natural person partners are liable for individual income tax and legal person partners are liable for enterprise income tax in accordance with existing applicable regulations. For partners who are subject to individual income tax, the tax amount will be calculated in accordance with two circulars that MOF and SAT issued in 2000 and 2008, respectively, on the collection of individual income tax on investors in partnership enterprises (Caishui  No. 91), and on deductions from partners’ taxable income (Caishui  No. 65).
Circular 159 also clarifies that the taxable income of a partnership enterprise includes the income distributed to the partners and the income retained by the partnership enterprise in the current year. Thus, the partners are subject to tax on the income of the partnership enterprise regardless of whether the partnership’s income has been distributed to them. According to Circular 159, of the entire taxable income of a partnership enterprise, the amount allocated to each partner will be determined by:
- The percentage of income to be distributed to each partner (the “percentage of distribution”) set forth in the partnership agreement;
- The percentage of distribution subsequently agreed upon by the partners if the partnership agreement is silent or unclear on the percentage of distribution;
- The percentage of paid-in capital contributed by the partners if no percentage of distribution can be agreed upon by the partners; or
- The number of partners pro rata if the percentage of paid-in capital contributed cannot be determined.
Circular 159 also states that, when calculating the enterprise income tax that they owe, legal person partners cannot offset their profits with the losses of the partnership enterprise. This is consistent with common practice regarding investment losses in the calculation of enterprise income tax.
Surprisingly, however, Circular 159 prohibits partners to a partnership enterprise from providing in their partnership agreement that they may distribute the enterprise’s entire taxable income to some, but not all, of the partners. This is inconsistent with Article 69 of the Partnership Law, which provides that, for limited liability partnerships, partners may make such provisions in their partnership agreement. Technically, the Partnership Law prevails over Circular 159, but partners to a partnership enterprise may want to hold off on including such provisions in their partnership agreement until MOF and SAT clarify their position so as to avoid any negative tax implications