Key Points:

  • New rules bring significant changes to the corporate income tax regime of nonresident enterprises with operations in China
  • The tax authority is now taxing the indirect transfer by a nonresident enterprise of its offshore intermediate company’s holding interest in a Chinabased company under certain circumstances

The Administrative Measures for the Collection of Corporate Income Tax on Non-tax Resident Enterprises on a Deemed Basis

On February 20, 2010 the State Administration of Taxation (SAT) promulgated the Administrative Measures for the Collection of Corporate Income Tax on Non-tax Resident Enterprises on a Deemed Basis, GuoShuiFa [2010] No. 19 (Circular 19). Circular 19 concerns the nonresident enterprise (NRE) that has a place of business (establishment) or a permanent establishment (PE) 1 in China. Under PRC corporate income tax law, if such NRE earns income in China attributable to the establishment/PE, the NRE is liable for 25-percent PRC corporate income tax. Circular 19 brings about significant changes to the corporate income tax regime of nonresident enterprises with establishments/PEs in China. The major changes are summarized as follows:

1. New Income Tax Calculation Method

Under the old rule, if the NRE cannot maintain complete and accurate accounting books, it will be taxed on a deemed profit basis i.e., the NRE applies a deemed profit rate of 10 to 40 percent of its gross revenue to arrive at the taxable income.

Circular 19 provides the following calculation methods in the event that the NRE does not have complete and accurate records of its activities in China.

Deemed Profit Method

This method should be used when the NRE can accurately determine its gross revenue but cannot ascertain its costs and expenditures. The calculation formula is:

Taxable Income = Gross Revenue x Deemed Profit Rate

Cost Plus Method

This method should be used when the NRE can accurately determine its cost but cannot ascertain its gross revenue. The calculation formula is:

Taxable Income = Cost/(1 - Deemed Profit Rate) x Deemed Profit Rate

Expenditure Method

This method should be used when the NRE can accurately determine its expenditures but cannot ascertain its gross revenue and costs. The calculation formula is:

Taxable Income = Expenditures/(1 - Deemed Profit Rate - Business Tax Rate of 5 Percent) x Deemed Profit Rate

2. New Deemed Profit Rate

Circular 19 for the first time clarifies the deemed profit rates for various types of businesses, which used to be based on the practice of local tax authorities and vary significantly across the country. The deemed profit rates are defined as follows:

  • Project construction, design and consulting: 15 - 30 percent
  • Management services: 30 - 50 percent
  • Other services or activities: No less than 15 percent  

Circular 19 also gives the tax bureau the authority to apply a higher rate if there is evidence that the actual profit rate of the NRE is noticeably higher than the prescribed rate. It is also important to note that if the NRE conducts various types of businesses in China that are subject to different deemed profit rates, it should calculate the relevant tax liabilities separately.

3. After-Sales Services

Another important development under Circular 19 concerns the provision of after-sales services e.g., installation, assembly, technical training, guidance and supervision in China provided by the NRE in connection with the sale of goods/equipment in China. If the sales contract fails to provide any fee for such after-sales service, or the service fee is not reasonable, the tax bureau is authorized to deem a service fee at a rate comparable to the same or similar services, or at no less than 10 percent of the total sales price if no such comparison exists.

4. Onshore and Offshore Services

Circular 19 seems to have abandoned the compulsory 60/40 allocation rule, which has been criticized by some commentators as arbitrary and inaccurate. According to this 60/40 allocation rule, if the NRE renders consulting services both in and outside China, the tax bureau requires at least 60 percent of the service revenue to be allocated as China-source income, regardless of what portion of the revenue was actually earned in China. Circular 19 appears to adopt a more reasonable approach towards services provided onshore and offshore: the NRE should allocate service income based on where the services are actually rendered and report only income derived from services rendered in China. However, if the tax authority has questions regarding the reasonableness and legitimacy of the allocation, it can require the NRE to produce supporting evidence and make its own allocation according to the work load, work schedule, cost and expenditures. If the NRE cannot provide the requested evidence, the tax authority may deem that all services were performed onshore and subject all revenue to PRC tax.

Notice on Strengthening the Administration of Corporate Income Tax Liability of Equity Transfer of Nonresident Enterprises

On December 10, 2009 the SAT issued the Notice on Strengthening the Administration of Corporate Income Tax Liability of Equity Transfer of Nonresident Enterprises GuoShuiHan [2009] No. 698 (Circular 698).

Circular 698 is significant as it marks the first time that the tax authority officially adopts the position of taxing the indirect transfer by a nonresident enterprise of its offshore intermediate company’s holding interest in a Chinabased company under certain circumstances. Circular 698 provides that if a foreign investor or an effective controlling party, through abusive arrangements, disposes of its equity interest in an offshore intermediate company holding an interest in a China-based company, and such holding company does not have a reasonable commercial purpose and is established with the intent of avoiding PRC corporate income tax liabilities, the tax authority has the right to invoke the principle of “substance over form,” disregard the existence of the holding company being used as a tax-avoidance vehicle, recharacterize the transaction as a transfer of the China-based company itself and impose PRC tax on the capital gains of the transfer. However, such recharacterization by the local tax bureau is subject to the review and approval of the SAT.

As part of its effort to strengthen the administration of equity transfers of nonresident enterprises, Circular 698 requires the nonresident enterprise disposing of its interest in a China-based company to file a corporate income tax return with the tax authority in charge of the transferee China-based company if the withholding agent is unable to or fails to withhold corporate income tax within seven days after the execution of the equity transfer agreement or seven days after obtaining the equity transfer price if the nonresident is prepaid the equity transfer price.

Another important obligation imposed on nonresident enterprises with respect to the indirect transfer of a Chinabased company applies when the intermediate holding company is located in a jurisdiction where the effective tax rate is lower than 12.5 percent or its foreign-source income is exempted from income tax in that jurisdiction. In this scenario the nonresident enterprise is required to file the following with the tax authority in charge of the Chinabased company within 30 days of the execution of the equity transfer agreement:

  • The equity transfer agreement;
  • Information about the relationship between the nonresident transferor and its holding company transferee in terms of capital, business operation, purchases and sales;
  • Information about the manufacturing activity, business operation, personnel, financials and properties of the holding company transferee;
  • Information about the relationship between the holding company transferee and the China-based resident company in terms of capital, business operation, purchases and sales;
  • An explanation of the reasonable commercial purpose of the holding company; and
  • Other materials as required by the tax bureau.

Circular 698 not only increases the compliance burden for the nonresident enterprise but also creates great uncertainties for the nonresident enterprise with respect to the transfer of its offshore company’s holding interest in a China-based company. The tax authority has not given any guidance on what constitutes “reasonable commercial purpose” and when it will invoke the “substance over form” principle. It is expected that detailed rules will be issued to address these issues.