Tax liability for non-resident enterprises engaging in service provision

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1 Tax liability for non-resident enterprises engaging in service provision More and more European companies are facing the question of whether they actually have to pay taxes in China when providing services to Chinese customers, and if so, to what extent. The tax liability of a non-resident enterprise can hereinafter be illustrated with three practical examples: Case 1. A German company delivers a machine to a Chinese customer. The Chinese company is located in Beijing. In order to put its machine into operation, the German company has signed a service contract with the Chinese customer and sent an employee to China for a period of less than 6 months. The value of the contract is CNY 500,000. Case 2. Like case 1 but in this example the German company sent an employee to China for a period of more than 6 months. Case 3. A Belgian company provides services to a Chinese customer without sending an employee to China or having any other kind of establishment in mainland China. The seat of the Chinese company is a small county town in Guangdong province. The value of the business is CNY 100,000. Generally speaking enterprise income tax, business tax and some additional taxes based on the business tax have to be taken into account. 1. Enterprise income tax i. Tax liability in general In terms of the enterprise income tax, the Chinese Enterprise Income Tax Law (hereinafter EITL ) distinguishes between resident and non-resident enterprises. A resident enterprise is an enterprise incorporated under the Chinese law or an enterprise incorporated under laws of a foreign country or other tax region but with its actual management located in China. Resident enterprises are normally subject to income tax levied at the rate of 25% within and outside China. To be considered as a non-resident enterprise, three requirements must be met: - The enterprise is incorporated under foreign law or law of other tax region; - Its actual management is located abroad; and - It either has an establishment in China or has generated revenue from Chinese sources without having an establishment in China. An establishment could be for instance a place of operation or administration, a place where services are rendered, a place of construction, or installation. 1

2 ii. Tax liability of non-resident enterprise without establishment in China A non-resident enterprise having no establishment in China is liable to pay enterprise income tax only for its income derived in China. Income in this sense consists principally of dividends and interest income. Under tax treaties other incomes sourced by a non-resident enterprise should not be subject to enterprise income tax in China unless it maintains a permanent establishment in China under the tax treaty. Permanent establishment is a definition used in bilateral tax treaties for the purpose of determining the right of a contracting State to collect tax from enterprises of the other contracting state. A foreign company will be deemed to have an establishment if it has provided services by sending an employee to China and the actual work period of the employee in China exceeds 6 months aggregately within a calendar year. All the EU Member States have concluded a tax treaty with China. Please note that the tax treaties with Malta, Belgium and the Czech Republic have not yet entered into force. All the tax treaties are available on the homepage of the State Administration of Taxation (SAT). Since 2009 the preferential treatment under the tax treaty does not apply automatically. According to the SAT Circular Guoshuifa (2009) No. 124 it is mandatory for non-residents to request approval for treaty benefits with the tax authority in charge. In this regard an agent, for instance the Chinese customer, can be appointed by the non-resident enterprise to carry out the procedure. However in practice many Chinese tax authorities still levy enterprise income tax on the service fees generated by non-resident enterprises without permanent establishment in China. In this context it is advisable to contact the relevant tax authorities at an early stage in order to clarify the local applicable tax characteristics. In case the local tax authorities levy a withholding tax, the following principles shall be applied: The competent tax authority assesses the tax liability of the foreign company pursuant to the present service contract and possibly additional relevant research. The tax rate for non-resident enterprises without establishment is 10%. Tax base is the total turnover that the foreign enterprise generates in China for the relevant project. No expenses related to the services are to be deducted in this case. And the Chinese customer is obliged to withhold the tax for the European company and to transfer it to the appropriate State tax authority. iii. Tax liability of non-resident enterprise with establishment/permanent establishment in China A non-resident enterprise with establishment/permanent establishment (hereinafter with establishment ) in China shall pay enterprise income tax on China-sourced income derived by the establishment, and also on income arising outside China but effectively connected with such an establishment. The location where the services are rendered is the decisive factor in determining the source of income. The tax rate for non-resident enterprises with establishment in China is 25%. Non-resident enterprises with establishments in China shall set up and maintain accounting books and records and accurately calculate the taxable income. The enterprise income tax is to be declared and paid on an actual basis. In case the company is unable to accurately calculate and file the taxable income due to incomplete bookkeeping, or for any other reason, the tax authority is entitled to assess taxable income using one of 2

3 the following methods: deemed profit based on total revenue, deemed profit based on costs and expenses or deemed profit based on operating expenditures. (1) Deemed profit based on total revenue Taxable income = gross revenue x deemed profit rate (2) Deemed profit based on costs and expenses Taxable income = total costs and expenses (1- deemed profit rate) x deemed profit rate (3) Deemed profit based on operating expenditures Taxable income = total costs and expenditures (1 - deemed profit rate business tax rate) x deemed profit rate The profit rate for the provision of services is normally 15-30% as determined by the relevant tax authority. iv. Case studies In case 1, by sending an employee to China for less than 6 months, the German company is a nonresident enterprise without establishment in China. The taxation regarding the enterprise income tax depends on the respective tax authority. In most districts of Beijing no enterprise income tax will be levied in this case. In other locations which do not follow the tax treaty, the German company must pay an enterprise income tax amounting to CNY 50,000 (CNY 500,000 x 10%) on a withholding basis. In case 2, by sending an employee to China for longer than 6 months, the German company is deemed to be a non-resident enterprise with establishment in China. Assuming the tax authority has assessed the taxable income using the method of deemed profit based on total revenue and the determined profit rate is 20%, the enterprise income tax payable shall be CNY 25,000 (CNY 500,000 x 20% x 25%). In case 3, the service has been rendered in Belgium. Therefore the income is not China-sourced income and no enterprise income tax is due. 2. Business tax i. Tax liability The Chinese taxation law distinguishes between business tax and Value-Added Tax (VAT). Companies engaging in the sale of goods are generally subject to VAT. Business tax is a turnover tax imposed upon activities involving services and intangible goods. Exceptions to this are processing, repair and replacement services, which are subject to VAT. A business tax has to be paid where either the service provider or the recipient is located in China. Therefore a business tax will be levied on foreign companies rendering services outside China to Chinese clients. Before January 2009 only services performed in China were subject to business tax. Business tax is calculated based on turnover and the applicable tax rate (Business tax payable = turnover x applicable tax rate). ii. Taxable income According to the preliminary regulations on business tax, turnover consists of the entire remuneration and the additional fees received by the taxpayer for providing the taxable service. The additional fees are more closely defined in the implementing rules on the preliminary regulations on business tax and 3

4 include allowances, penalties, interest, commissioned payments and charges, costs, etc. received by the taxpayer. If taxable services are offered at obviously low prices without proper justification, tax authorities are entitled to determine the turnover at their own discretion. iii. Taxation rate Under the provisional regulations on business tax, the tax rate for service amounts to 5%. iv. Taxation method For non-resident enterprises subject to business tax, self-declaration is required where it has an establishment in China. For non-resident enterprises without business establishment in China the Chinese customer is obliged to withhold the tax payable by the non-resident enterprise and to remit it to the relevant local tax authority. v. Case studies In the abovementioned three cases both the German company and the Belgian company are liable to pay business tax, since the company receiving the service is located in China. In the first two cases the payable business tax amounts to CNY 25,000 (CNY 500,000 x 5%). In case 3 5,000 CNY (CNY 100,000 x 5%) business tax is levied. 3. Additional taxes based on the business tax i. Tax liability In China there are two additional taxes based on the business tax: the urban construction tax and the education surcharge. Until December 1 st 2010 foreign companies were excluded from paying these taxes. As part of the programme of tax unification, this privilege has been abandoned by the Chinese government. Therefore foreign companies subject to business tax in China are now liable to pay these additional fees. ii. Taxable base The base for calculating urban construction tax and the education surcharge is the amount of the business tax payable by the foreign companies. iii. Taxation rate The urban construction tax rates are set at 7%, 5% and 1% of the business tax depending on whether the business is located in a city, county town or a place other than a city or town. In the case of a nonresident enterprise, the taxation rate depends on the registered seat of the Chinese customer. In terms of the education surcharge two taxation rates have to be considered. The first one is the national education surcharge amounting to 3%. Additionally the provinces are encouraged to collect a local education surcharge which can be up to an additional 2%. 4

5 iv. Taxation method Similar to the taxation of business taxes, foreign companies with business establishment in China have to file self-declaration with the relevant local tax authority. For foreign companies without a legal entity in China, the Chinese customers have to function as a withholding agent. The tax is calculated based on business tax amount and the applicable tax rate (= business tax amount x applicable tax rate). v. Case studies Since all companies in our case studies have to pay business tax, they are all subject to the additional taxes based on the business tax. Case 1 and case 2: the Chinese client of the German company is located in the city area of Beijing. The urban construction tax rate is therefore 7% and the urban construction tax is CNY 1,750 (CNY 25,000 x 7%). The education surcharge is CNY 750 (CNY 25,000 x 3%). In Beijing, the local education surcharge will be levied from 1 st January In case 3, the company is subject to the local education surcharge amounting to CNY 500 (CNY 25,000 x 2%) from 1 st January Case 3: The Belgian company has to pay an urban construction tax in the amount of CNY 250 (CNY 5,000 x 5%), since the Chinese company is located in the town area. The education surcharge is CNY 250 (national education surcharge: CNY 5,000 x 3% and local education surcharge: 5,000 x 2%). Contact the Centre at: Room 910, Sunflower Tower 37 Maizidian West Street Chaoyang District Beijing, T: F: The EU SME Centre assists European SMEs to export to China by providing a comprehensive range of free, hands-on support services including the provision of information, confidential advice, networking events and training. The Centre also acts as a platform facilitating coordination amongst Member State and European public and private sector service providers to SMEs. The Centre s range of free services cover: Business Development provision of market information, business and marketing advice Legal legal information, ask the expert initial consultations and practical manuals Standards standards and conformity requirements when exporting to China HR and Training industry and horizontal training programmes Access to a service providers directory and information databases Hot-desking free, temporary office space in the EU SME Centre to explore local business opportunities Any other practical support services to EU SMEs wishing to export to or invest in China. Disclaimer enquiries@eusmecentre.org.cn This document is provided for general information purposes only and does not constitute legal, investment or other professional advice on any subject matter. Whereas every effort has been made to ensure that the information given in this document is accurate, the EU SME Centre accepts no liability for any errors, omissions or misleading statements, and no warranty is given or responsibility accepted as to the standing of any individual, firm, company or other organisation mentioned. Publication as well as commercial and non-commercial transmission to a third party is prohibited unless prior permission is obtained from the EU SME Centre. The views expressed in this publication do not necessarily reflect the views of the European Commission. Date: May, 2011 The EU SME Centre is a project funded by the European Union. 5

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