Providing cross border services to China: beware of tax pitfallsOverseas companies not tax resident in China and transacting with Chinese clients need to be aware of the various tax systems in place. These rules also apply when an overseas parent company provides services to its own China subsidiary.
Many overseas companies that are not registered as legal entities or tax resident in China, provide services to Chinese clients in cross border transactions. Services provided by such Non-Resident Companies (NRCs) range from consulting and technical services to transport, design and construction services and may be performed both inside and outside China. No matter where an NRC performs the services for a client located in China, the tax implications of the transaction must be considered carefully.
In the absence of proper tax planning for cross border service transactions, NRCs may have problems collecting fees from their China-based clients, or may find that they were unaware of taxes that must be collected by the Chinese tax authorities before the client can pay any invoiced fees. Furthermore, when the time period of a project or a series of related projects performed inside China exceeds certain limits (often 183 days), the NRC may be considered a Permanent Establishment (PE) in China for Enterprise Income Tax (EIT) purposes.
Common forms of tax
Since implementation of the 2008 EIT law by the State Administration of Taxation (SAT), all NRCs obtaining income from the provision of services to clients in China are subject to taxation on their earnings. The most common forms of taxation applicable to these transactions include withholding tax (WT), business tax (BT) (although this is being phased out) and more recently, value added tax (VAT), which now applies to service transactions provided in many locations in China. While EIT instead of WT applies in those situations in which an NRC is deemed to have a PE in China, payment of the tax is usually accomplished through the withholding system. It should be noted that before any payment by a Chinese client to an NRC is allowed, the Chinese client must show evidence of required tax payments to the bank that handles the payment transaction.
Negotiating a service contract
Any NRC providing services to a Chinese client should begin the process by negotiating and entering into a service contract with the client. This should specify the nature and duration of the services, the fees charged, payment terms, deadlines and other relevant details. It’s possible to set out fees so that the NRC receives a net amount, whereby the Chinese client essentially absorbs relevant taxes. However, with the exception of VAT, taxes paid are still formally considered to be paid by the NRC and as such, are not tax deductible through the client’s own EIT quarterly or yearly filing process. Therefore most Chinese clients refuse to bear the withholding tax burden.
Once the terms are agreed and a contract is signed, the Chinese client must register the contract with the local tax bureau within 30 days of signing. The tax officer will usually appoint the client to act as a withholding agent and will also instruct the client on which taxes apply, as well as the taxable portion of the fees charged by the NRC (usually 100% of service fees). Any NRC that enters into a service agreement with a Chinese client should take measures to ensure that the client performs this registration step. Most problems that arise once services are completed and invoices are issued to Chinese clients are due to non-registration of contracts by clients. Failure to register service contracts can not only cause long delays in payments to the NRC, but in severe cases, cause the payment to be completely disallowed by local Chinese authorities.
Failure to pay may result in fines
In most cases the first tax applied to a cross border service transaction is WT. This is usually a flat 10% rate, based on the total fee. If, however, the service contract demonstrates that a portion of the fees charged are direct costs of the service provider (for example, costs of equipment or spare parts) which are being passed on to the client, those costs may be deductible from the taxable portion of the fees, especially if agreed with the tax bureau at the time of service contract registration. It should be noted that there is no legal means of avoiding the payment of WT. Additionally, if the Chinese client fails to withhold and pay the WT as required, the client may face severe penalties and fines and the NRC may face difficulties in doing any future business in China.
Where an NRC is deemed to have a PE in China (a presence in China longer than 183 days in most cases) the law states that the NRC must register for EIT payment on the earnings associated with the PE. EIT of 25% is then paid on an actual basis if the NRC maintains accurate accounting records in China, or if not, on deemed profit. Deemed profits range from 15% to 50% of total contract value, depending on the service provided. In practice, many tax bureaus do not allow NRCs to register for EIT filing and payment on their own behalf. The withholding agent system is more commonly used in these cases and the Chinese client will usually act as the withholding agent for tax filing and payment purposes. For this reason, many NRCs that are deemed to be PEs choose not to maintain accurate accounting records in China (which would be visible to the client) and so pay 25% EIT on the deemed profit basis.
In the past, in addition to WT or EIT, NRCs that provided services to Chinese clients were also liable for payment of BT, usually at 5% of the service transaction value. As in the case of WT, the client in China acted as withholding agent and paid the tax to the tax bureau prior to making payment to the NRC service provider. However, as China is now moving to a VAT system, BT is being, or has already been, phased out in many locations. It should be noted that BT is a turnover tax for which the service provider has sole liability. So, when BT applies to a transaction, the NRC carries the tax burden and the withholding system is used to ensure payment.
VAT is normally borne by the end user of products or services. Inside China, a company may credit all VAT paid when buying goods or services (input VAT) against VAT collected when selling goods or services (output VAT). During a tax period, the difference between the input VAT and output VAT is the total VAT liability of the company for the tax period. VAT not only applies to service transactions within China’s borders, but also to any services that are purchased from an overseas NRC (such services are considered to be imported services).
Avoiding potential surprises
Therefore, where a Chinese client buys services (imports services) from a NRC, VAT applies to the transaction. The VAT rate is dependent on the type of service provided (ranging from 6% to 17%). Because the NRC typically may not be registered as a VAT taxpayer in China, it has no means by which to collect the applicable VAT from the Chinese client and subsequently pay the tax to the China tax bureau. Therefore, as the end user of the service, the Chinese client should pay the applicable VAT directly to the tax bureau as its own liability, rather than attempting to withhold the tax from the payment that is to be made to the NRC. The Chinese client may then credit the VAT paid as input VAT. Unfortunately, many Chinese clients may still be accustomed to the previous mandatory withholding of BT on imported services and thus still attempt to withhold the VAT from their payments to the NRC service provider. In order to avoid any potential surprises, NRC service providers are strongly advised to clarify with their Chinese clients how the applicable VAT will be handled in the transaction.
Claiming a foreign tax credit
In cases where a double taxation avoidance treaty exists between China and another country, an NRC that pays WT in China is usually allowed to claim a foreign tax credit in their own country when filing corporate income tax. It should also be noted that other treaties may offer a further reduction in tax. In all cases where the Chinese client in a transaction withholds the required tax from invoiced payments, the NRC should request copies of the tax payment certificates that are issued by the China tax bureau as evidence of the tax payment. It may otherwise be difficult to substantiate the claim for a foreign tax credit in the home country.
Seek expert advice
It should be noted that the final outcomes in cross border service transactions may depend on many factors, including the specific locations of the parties involved, the types of services rendered, the wording of service contracts or agreements, how the local tax bureau interprets regulations, and even the Chinese client’s understanding of the transaction process or its ability to make payments overseas in foreign currencies. For this reason, it is strongly recommended that any NRC planning to provide services to clients in China seeks the advice of a knowledgeable China tax consultant during the initial planning stages of the transaction.
For more information, contact:
Nexia TS Shanghai
T +8621 6390 6000