China scrutinizes non-resident enterprises

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An increasing number of cases are being published in which PRC tax authorities are reported to have deemed a non-resident enterprise to have a permanent establishment (PE) due to its services performed in China.

According to a report on the Hainan local tax bureau’s website, the Nanjing state and local tax bureaus, in Jiangsu province, co-operated in such an investigation to collect RMB5.89 million (US$855,000) in earned income tax (EIT) and RMB31 million in individual income tax (IIT).

The local tax bureau started the investigation when it learned that a Chinese company had paid large service fee amounts to an offshore company. As the services were rendered over a long period, the local tax bureau decided to look into whether the offshore company had created a PE in China. The local tax bureau also asked the state tax bureau to review the service contract submitted by the company to the state tax bureau for recordal purposes.

iStock-500488176After reviewing the service obligations in the service contract, the two bureaus suspected that the offshore company would need employees in China to perform its obligations. After questioning the PRC company’s employees and conducting an on-site investigation, the tax bureaus found that the offshore company did have technical staff in China. After further investigation, the tax bureaus confirmed that these technical staff had stayed in China long enough to establish a PE.

Therefore, the offshore company was liable to pay EIT and withhold IIT for its technical staff working in China. In order to determine the EIT payable, the state tax bureau allocated RMB157.12 million from the total service fees (RMB368.31 million) to the PE and taxed the PE using the deemed profit method.

University case

On 12 August 2016, China Taxation News reported that the Ningbo State Tax Bureau in Zhejiang collected RMB10.88 million in EIT from a UK university on service fees received from a Chinese university (payer).

The payer was a Sino-foreign co-operative university jointly owned by the UK university and a Chinese university. The UK university and the payer entered into a service agreement, according to which the former provided education services to the latter. These education services included seconding experienced teaching and management staff to China.

The tax bureau decided to investigate because the UK university had been receiving increasing service fees in recent years, but had never paid EIT in China. A key issue under investigation was whether the seconded staff created a PE for the UK university.

The UK university argued that no PE was created because the seconded staff signed labour contracts with the payer and therefore were the payer’s employees. The tax bureau rejected this argument because the investigation showed that the seconded staff were hired and paid by the UK university.

On this basis, the tax bureau decided the UK university had a PE in China and was liable for tax on income attributable to the PE. In order to determine the EIT payable, the tax bureau allocated 47% of the total service fees to the PE and taxed the PE using the deemed profit method.

Due to the tax recordal mechanism for outbound remittances, China’s tax authorities can examine outbound payments to determine whether a PE is created. The Jiangsu and Zhejiang cases indicate the PRC tax authorities are being especially rigorous in searching for service PEs. We expect this trend to continue.

If a service PE is created, the offshore service provider’s EIT burden depends largely on how much income is attributable to the PE. As such, every offshore service provider should maintain sufficient documentation on the income allocation between services performed inside and outside of China to prevent tax authorities from arbitrarily allocating income to the PE.

Business Law Digest is compiled with the assistance of BAKER MCKENZIE. Readers should not act on this information without seeking professional legal advice. You can contact Baker & McKenzie by e-mailing Danian Zhang at danian.zhang@bakermckenzie.com, or for general enquiries contact Anand Ramaswamy at anand.ramaswamy@bakermckenzie.com

Additional copy regarding new treaties with India was compiled by Nishith Desai Associates (NDA), a research-based international law firm with offices in Mumbai, New Delhi, Bangalore, Singapore, Silicon Valley and Munich.