China releases new rules for its individual income tax reform

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China is continuing to reform its Individual Income Tax (IIT) regime. After recently revising its Individual Income Tax Law, China has released several more rules to reshape the country’s IIT regime. These rules include the new Implementing Regulations for Individual Income Tax Law (the Implementing Regulations), additional special deduction rules (Guo Fa [2018] No. 41 and SAT Bulletin [2018] No. 60), tax withholding rules (SAT Bulletin [2018] No. 56 and SAT Bulletin [2018] No. 61), self-filing rules (SAT Bulletin [2018] No. 62) and transitional rules for IIT incentives (Cai Shui [2018] No. 164). These new rules are effective from 1 January 2019.

These new rules:

  • Adjust the “6-year rule” under the tax resident concept, making it possible for expatriates working in China who qualify as Chinese tax residents to still avoid PRC IIT on their worldwide income;
  • Introduce for Chinese resident taxpayers a set of additional special deductions, which expatriates working in China can choose to enjoy instead of the currently available tax-exempted allowances for expatriates;
  • Clarify preferential tax treatments for IIT incentives during transition periods to solve uncertainties taxpayers may encounter under the new IIT regime;
  • Introduce the accumulative IIT withholding method for withholding agents to withhold resident taxpayers’ salary and wages income;
  • Revise the anti-avoidance rule, but high-net-worth individuals still need to pay attention to follow-up rules;
  • Delete the controversial “deemed sales rule” in the draft Implementing Regulations.

This article will introduce the important changes to the old IIT regime and discuss their implications for both employers and employees.

Type

 

Item eligible for deduction

 

Deduction amount (RMB)

 

Children’s education

 

Pre-school education fees (from 3 years old) to higher education fees (doctoral)

1,000/month per child
 

Continuing education

 

Academic (degree) education fees for education received in China

400/month
 

Education fees for professional licences

3,600/year
 

Housing loan interest

Loan interest on a taxpayer’s first house in China purchased for the taxpayer or for the taxpayer’s spouse 1,000/month
 

Housing rental fees

Housing rental fees when the taxpayer or taxpayer’s spouse owns no house in the taxpayer’s main working city 800, 1,100 or 1,500/month depending on the city
 

Caring for the elderly

 

Expenses related to caring for the elderly
parents (60 or older) and grandparents
(60 or older with no living children)

If the taxpayer is an only child 2,000/month
If the taxpayer is not an only child No more than 1,000/month
 

Medical treatment for
serious disease

Medical expenses exceeding RMB15,000
borne by an individual under the national
medical insurance programme
Deduct according to actual amount,
capped at 80,000/year

 

1.Tax resident

Expatriates working in China will qualify as a Chinese tax resident more easily after the IIT reform, potentially exposing them to greater IIT liability. The time presence threshold for a non-domiciliary to become a Chinese tax resident has been reduced from a “full year” to 183 days in a tax year. (A “full year” means the person is not absent from China for more than 30 consecutive days in a single trip or more than 90 cumulative days across multiple trips during the tax year.) This change in time presence threshold is important to expatriates working in China because by qualifying as a Chinese tax resident, their worldwide income will become subject to Chinese IIT.

Despite this change in the time presence threshold, expatriates working in China can still prevent their worldwide income from becoming subject to Chinese IIT by carefully planning their travel outside China. A non-domiciliary who stays in China for at least 183 days in a year is exempt from taxation on income that is both foreign-sourced and foreign-paid if that person has not stayed in China for at least 183 days in each year during the past consecutive six-year period (inclusive of the current year) or has been absent from China for more than 30 consecutive days in a single trip in one calendar year during that six-year period (6-year rule).

Thus, while it is easier to become a Chinese tax resident under the new IIT rules, an expatriate working in China can still reduce their Chinese IIT liability by travelling outside China for more than 30 consecutive days in one calendar year every six years.

2. Additional special deductions

With the introduction of additional special deductions, both employers and employees will need to evaluate the additional special deductions in terms of their tax planning and their tax responsibilities.

2.1 Know what additional special deductions are available: The table on Page nine shows the additional special deductions available to Chinese tax residents as introduced in the final version of the Additional Special Deduction Measures.

2.2 Choose to enjoy additional special deductions or tax-exempted allowances: The additional special deductions are only available to Chinese tax residents. An expatriate who qualifies as a Chinese tax resident can choose to either enjoy these newly introduced additional special deductions or enjoy the tax-exempted allowances currently available to all expatriates (please refer to section 3.1 for more information on tax-exempted allowances).

2.3 Maintain supporting documents: Both employees and employers have document retention responsibilities for the additional special deductions. Employees, as taxpayers, must maintain supporting documents (rental contracts, medical bills, etc.) for five years after the filing period. Employers, as withholding agents, must maintain the relevant information provided by employees for five years from the withholding year.

Although this document retention requirement will increase employer administrative costs, employers will not be responsible for verifying the accuracy of the information provided by employees. Without the added burden of verifying employee-provided information, employers should find some relief in controlling the overall costs related to administering the additional special deductions.

Nonetheless, if an employer discovers that an employee has submitted false information, the employer may ask the employee to correct the information. If the employee refuses, the employer must notify the tax authority. It seems that the final IIT rules give the employer an option whether to ask the employee to correct the false information. However, it remains to be seen whether the employer will bear any adverse consequences if it chooses not to ask the employee to correct the information when it knows it is false.

3. Preferential IIT treatments

The Ministry of Finance and the State Administration of Taxation jointly released transitional rules for certain IIT incentives that are typically important for employees in China. In particular, employees will be pleased to see that these transitional rules retain (at least temporarily) popular preferential tax treatments for expatriate allowances, annual bonuses, equity incentive income and severance.

3.1 Tax-exempted allowances for expatriates: Expatriates working in
China, regardless of their tax residency status, can enjoy eight tax-exempted allowances for housing, language training, children’s education, meals, laundry, relocation costs, home leave, and onshore and offshore business travel. However, the tax-exempted allowances for housing, language training and children’s education will only be available until 31 December 2021. During the next three years, expatriates who qualify as Chinese tax residents can choose whether to enjoy these three tax-exempted allowances or enjoy the additional special deductions instead. Starting from 1 January 2022, expatriates will no longer be able to enjoy these three tax-exempted allowances. Other allowances will remain tax-exempt for now, but their tax-exempt status could change at any time pending new rules being issued.

3.2 Annual bonus for resident taxpayers: For employees who are resident taxpayers, the preferential tax treatment on annual bonuses remains unchanged until 31 December 2021, meaning that each resident taxpayer can choose whether to include their annual bonus in their comprehensive income or have it taxed separately. Starting from 1 January 2022, annual bonus compensation must be included in comprehensive income for
IIT calculation.

For the next three years, most employees will probably choose not to include their annual bonus in their comprehensive income as the annual bonus may be subject to a lower tax rate if taxed separately. However, some low-salary employees may find it more beneficial to include annual bonus compensation in their comprehensive income if they have large deductions under the comprehensive income category that are not fully utilized by normal salary income. Such low-salary employees can then use these deductions to offset their annual bonus compensation to lower their taxable income and thus reduce their IIT burden on annual bonus income.

Non-resident taxpayers cannot enjoy the preferential tax treatment on annual bonus compensation under the current rules. However, it remains to be seen whether China will release new rules to provide similar preferential tax treatment to non-resident taxpayers.

3.3 Equity incentive income for resident taxpayers: Under the new transitional rules, resident taxpayers working in China will receive a more favourable tax treatment on their PRC equity incentive income when the underlying equity incentive is held for less than 12 months. Previously, all taxpayers, including resident taxpayers, were required to divide the equity incentive income by the actual number of months the taxpayer was working in China and holding the equity incentive (capped at 12 months) to determine the applicable tax rate.

From 1 January 2019 to 31 December 2021, a resident taxpayer working in China who receives qualified equity incentive income will aggregate all the equity incentive income received within the tax year and then divide that by 12 to determine the applicable tax rate. For example, if the resident taxpayer receives a stock option on 1 January 2019, exercises that stock option on 31 May 2019 and obtains equity incentive income of RMB120,000 under the old method, the resident taxpayer’s equity incentive income would have been divided by 5 to determine the applicable tax rate (i.e., 20%).

Under the new method, the resident taxpayer’s equity incentive income will be divided by 12 to determine the applicable tax rate (i.e., 10%). Thus, the new tax calculation method is more favourable for a taxpayer who works in China while holding the equity incentive for less than 12 months.

While the tax calculation method on a resident taxpayer’s equity incentive income has been changed, the resident taxpayer is still subject to the Circular 35 filing requirements.

Currently, no specific rules address the tax treatment of equity incentive income received by non-resident taxpayers. It remains to be seen whether non-resident taxpayers can receive preferential tax treatment on equity incentive income under the new IIT regime.

3.4 Severance for all taxpayers: All employees, regardless of their residency status, can enjoy the preferential tax treatment on severance. The portion of severance not exceeding three times the local average salary in the previous year is exempt from IIT, while the portion exceeding three times the local average salary in the previous year is taxed as a separate income stream by applying corresponding annual IIT rates for comprehensive income. Unlike the other rules discussed, this rule is not transitional and will remain in effect indefinitely.

4. Accumulative IIT withholding method

Another significant change in the new IIT regime is the accumulative IIT withholding method for resident taxpayers’ salary and wages. Employers must withhold each resident taxpayer employee’s taxes based on the cumulative income the employee has received from the employer
during the current tax year. Thus, an employee’s after-tax monthly salary and wages might decrease over the course of the year as the employee’s cumulative annual income increases over time triggering higher applicable tax rates from one month to the next.

As each employer withholds taxes at the applicable tax rate based on the income paid by that employer only, a taxpayer who changes jobs during the year would likely underpay taxes on the salary and wages earned from the second employer because the second employer would withhold taxes at a rate commensurate only with the income paid by it and not with the combined income paid by both employers. That employee would then need to conduct an annual filing and pay the underpaid taxes. Even though the current law does not require the second employer to ensure the employee conducts the annual filing and pays the underpaid taxes, the tax authority may nonetheless pressure the second employer to recover the underpaid taxes.

Finally, many employment contracts require the employer to pay the employee’s monthly after-tax income in a fixed amount. Employers with these employment contracts should exercise care to correctly calculate the withholding taxes for this type of arrangement under the new accumulative IIT withholding method.

5. Anti-avoidance rule

While it was hoped the Implementing Regulations would define some key IIT anti-avoidance concepts, the newly published version only includes an anti-avoidance rule imposing interest on tax adjustments.

The rule imposing interest on tax adjustments establishes that interest accrues for the period the tax has remained unpaid at a rate defined as the base rate for renminbi loans published by the
People’s Bank of China on the last day of the filing period of the tax year to which the tax is attributable.

As the anti-avoidance rule is an important component of the IIT reform and no detailed rules have been released yet, we expect the SAT will issue a separate set of anti-avoidance rules.