Understanding China's tax treaties and withholding taxesDealing with withholding taxes in transactions with Chinese companies can be a major challenge.
When foreign companies are trying to plan for or deal with withholding taxes in their transactions with Chinese entities without any conditions or exceptions, the withholding tax will be withheld from any payments made by Chinese entities to foreign entities. The default withholding tax rate on these transactions is 10%, but the rates can vary from the default when a Double Taxation Avoidance Treaty (DTAT) is in place between China and the income recipient’s country. More complicated than this is how withholding taxes may apply to service transactions in which the foreign entity provides chargeable services to a Chinese entity.
Chinese withholding tax
While it is common for overseas non-resident companies (NRCs) to provide services to Chinese clients or their own subsidiaries in China, it is often unpredictable as to whether Chinese withholding tax applies, and if it does apply, which factors would determine both the tax basis and tax rates. China’s local in-charge tax authorities consider each case and each transaction on its own merits, based on the final documentation that is submitted for transaction tax clearance. No absolute certainty regarding applicable taxes and tax rates is obtainable until tax officials have reviewed the tax clearance documentation and made their decision. Having said that, it is possible to provide the general practice framework within which taxes are assessed on the service activities of NRCs.
The application of DTATs
China’s 2008 Enterprise Income Tax (EIT) law states that 10% withholding tax or 25% EIT applies to any transaction in which a NRC provides services to a Chinese entity. However, China has DTATs in place with nearly 100 countries and territories, and most of the treaties invoke the concept of permanent establishment (PE) to determine whether EIT or withholding tax (WT) is applicable to the activities of a NRC in China (and vice versa). Even though the EIT law allows for a NRC to file EIT on an actual basis, it is rarely done. Chinese tax authorities almost always insist that taxes (either WT or EIT) be withheld from the payment made by the China-based service recipient. As explained below, there are differences in the tax outcome when EIT is withheld rather than WT.
In addition to the fixed location, construction site or assembly site criteria for PE creation, most DTATs also define a PE as “the furnishing of services, including consultancy services, by [a NRC] through its employees or other personnel, when the same or connected project continues for a period (or periods) aggregating more than six months within any 12-month period.” While this definition appears straightforward enough, the China State Administration of Taxation (SAT) interpretations and usual in-charge tax bureau practices play the most significant roles in determining when and how WT or EIT applies.
Three DTAT factors
Firstly, the SAT interprets "employees or other personnel" as being either direct employees of the NRC, or any other individuals controlled by and/or receiving instructions from the NRC. Even if the NRC has no employees present in China, use of a subcontractor located in China may constitute formation of a PE by the NRC. Furthermore, in counting the six months, presence of a NRC “employee or other personnel” in China for even one day during a given month is counted as a full month. Although this counting method was officially invalidated in 2011, no new method has been introduced to replace it, so most local in-charge tax authorities still continue to count months by this method. This is clearly a trap into which many NRCs unwittingly fall.
Secondly, the SAT interprets the idea of NRC “connected projects” as having any one of the following characteristics:
1. The individual projects are covered by a single master contract
2. The projects are covered by different contracts, but are concluded with the same or a related party
3. The projects are covered by different contracts where the execution of one project is a prerequisite to another
4. The projects are covered by different contracts but the nature of the work is the same
5. The services under different projects or contracts are performed by the same people
If any one of these conditions exists, the service is considered to be a connected project and the NRC will have created a PE in China. Again, many NRCs fall into this category without knowing it.
A third DTAT factor that in-charge tax authorities consider in determining whether EIT or WT applies to a service transaction, is the nature of the profits related to the service provision by the NRC. If a tax official decides that the profits are “business profits” as outlined in Article 7 of most DTATs, EIT will apply if the NRC is determined to have a PE. In most cases, the authorities then require that the service recipient in China acts as a withholding agent to ensure that EIT is withheld from payment to the NRC. The most common method of assessing the EIT that should be withheld is a “deemed profit” method, which uses a “deemed profit rate” (DPR) as a percentage of the total service fee to calculate the taxable income. The minimum DPR is 15% and may be as high as 50%. The tax withheld is then 25% of this taxable income.
Just as likely, and often even in cases where no PE is determined to exist, in-charge tax authorities may invoke another provision of most DTATs, which provides for an ill- defined “other income” category that is subject to 10% WT, based on 100% of the service fees charged. This treatment is very common when NRCs charge “management fees” or similar service fees to their subsidiaries or related parties in China. It is sometimes used in the same way even if the service recipient is not a related party.
Making the most of the benefits
It should be noted that in addition to the frequently inconsistent or confusing practices used by Chinese tax officials, benefits under DTATs are not automatic. The NRC service provider has sole responsibility to file an application for DTAT benefits and to provide evidence of DTAT applicability. Many NRCs are either unaware of this or have no representative in China to assist in the process. Chinese service recipients (if not related to the NRC) usually have no interest in assisting their NRC service providers in this process. Therefore many NRCs pay tax (or higher tax) where terms of a DTAT may otherwise offer protection. Any NRC planning to provide services in China, or working through unexpected withholding tax in a payment receipt, should seek the assistance of a Chinese tax professional to apply for and discuss potential DTAT benefits with the appropriate tax bureau, on the NRC’s behalf.
For more information, contact:
Nexia TS, China
+86 156 1833 1281
Nexia TS, China
+86 21 6390 6000 (ext. 207)