On February 20, 2010, the State Administration of Taxation (SAT) issued Guo Shui Fa  No. 18 — the “Measures for the Administration of Taxation on Representative Offices of Foreign Enterprises” (“Measures”) to reform the taxation rules applicable to the People’s Republic of China’s representative offices of foreign enterprises (“Rep Office”). The Measures revise existing Rep Office taxation rules by, among other things, abolishing previous tax exemptions and increasing the minimum deemed profit rate. Foreign companies that operate Rep Offices in China may be substantively impacted by these new policies, which are retroactively effective from January 1, 2010.
Prior to effectiveness of the Measures, Rep Offices were taxed in one of three ways, (a) based on their actual profits (“Actual Profit Method”), (b) based on their “deemed profits” (“Deemed Profit Method”) and (c) zero tax rate (“Tax Exemption”) when certain criteria were met. The key changes brought by the Measures are:
a) Five Percent Higher Deemed Profit Rate
According to the Measures, Rep Offices will be taxed in only two ways, the Actual Profit Method and the Deemed Profit Method. If a Rep Office is able to properly record operations in its financial accounting books and accurately calculate its taxable income and profit through proper reflection of its actual functions performed and risks assumed, the Rep Office may report its returns based on such records to the tax authorities on a quarterly basis. This method of Rep Office taxation, the Actual Profit Method, 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 can not 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, depending on which amount can be accurately recorded by the Rep Office. The tax authority will designate a deemed profit rate to the Rep Office and calculate the taxable income based on the deemed profit rate. To date, as a practical matter, only approved rep offices of foreign law and accounting firms have received approval for Actual Profit Method taxation.
Retroactively effective from January 1, 2010, the minimum deemed profit rate under the Deemed Profit Method increased from 10 to 15 percent. As the Measures only provide a minimum deemed profit rate, it is possible that local tax bureaus may determine a higher deemed profit rate for a Rep Office. According to calculations generated by an international CPA firm, for a Rep Office whose taxable income is calculated based on its costs under the Deemed Profit Method, the actual tax burden may increase by about 24 percent, as compared to the original tax burden under a 10 percent deemed profit rate. The Measures further clarify the method for calculating costs arising from purchasing fixed assets, interest income, entertainment expenses, contributions and advances from the Rep Office’s parent entity.
b) Abolishment of Tax Exemption
The Measures abolish the Tax Exemption for Rep Offices by repealing several previous tax regulations applicable to Rep Offices, including 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 Measures provide that, if special tax treatment appearing in tax treaties or agreements applies to a Rep Office, the Rep Office may separately apply for the special tax treatment.
c) Application of Value-Added Tax (VAT) to Rep Offices?
The 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. As Rep Offices are not allowed to directly engage in the sale of goods, it is unclear how the tax authorities will implement this new requirement.
In sum, the Measures represent government efforts to enhance the regulation of Rep Office taxation. Foreign companies operating a Rep Office in China may be required to bear a higher tax burden and be subject to closer supervision by Chinese tax authorities. It is expected that more national and local implementing rules will be promulgated in the near future to provide further clarification. Existing Rep Offices that enjoyed tax exemptions prior to the issuance of the Measures should reexamine whether the Rep Office is still eligible for tax exemption under a treaty or other arrangements. Foreign companies are also advised to consider restructuring current Rep Offices into other entity forms, such as wholly foreign-owned enterprises, which may now make more sense from operational and tax perspectives.