Triggering Permanent Establishment In China
China has many foreign companies operating within its borders. Some of these enterprises have permanent establishment in China while others do not. In either case, these enterprises are taxed on their China source income.
In general, only their China source income is taxable in China, with one notable exception. If the foreign source income is effectively connected with the permanent establishment (PE), the income is taxable in China. Effectively connected means that the foreign enterprises establishment owns equity interest or debt claim giving rise to income, or the establishment owns, manages, and controls properties giving rise to income.
The tax treaty between the U.S. and Chinese governments provides the framework for taxation of U.S. companies operating in China.
Permanent establishment
The income tax treaty between the U.S. and Chinese governments was signed on April 30, 1984 and became effective on November 21, 1986. The model income tax treaty produced by the Organization for Economic Cooperation and Development (OECD) as well as the U.S. Department of the Treasury formed the basis of the provisions within the ratified treaty. The importance of determining PE rules was recognized as a key consideration in the drafting of the treaty.
Article 5 of the treaty defines PE for taxation of businesses from either country operating in the others jurisdiction. In the treaty, PE is defined as a fixed place of business through which the business of an enterprise is wholly or partly carried on. PE, under the terms of the treaty, includes:
* A place of management
* A branch
* An office
* A factory
* A workshop
* A mine, an oil or gas well, a quarry, or any other place of extraction of natural resources.
PE also includes:
* A building site, construction, assembly or installation project, or supervisory activities in connection therewith, but only where such site, project or activities continue for a period of more than six months
* An installation, drilling rig or ship used for the exploration or exploitation of natural resources, but only if so used for a period of more than three months
* The furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only where such activities continue (for the same or a connected project) within the country for a period or periods aggregating more than six months within any 12-month period
Conversely, PE does not include:
* The use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise
* The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery
* The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise
* The maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise
* The maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character
* The maintenance of a fixed place of business solely for any combination of the activities mentioned in subparagraphs (a) through (e), provided that the overall activity of the fixed place of busine 00004000 ss resulting from this combination is of a preparatory or auxiliary character
What does all this mean? The situations that create PE can be summarized as follows:
* A foreign company that has an establishment or a place of business in China
* A foreign company that has employees working in China for a certain period of time (generally six months or more in any 12-month period)
* A foreign company that appoints an agent to conclude contracts or accept orders in China.
Tax implications
Foreign companies with PE are generally taxed on net income. Foreign enterprises that do not have any PE in China are generally taxed on gross income. The types of income may take the form of dividend, interest, service fees, commissions, and royalties that are paid from a resident enterprise in China to the recipients outside China.
Effective from January 2008, Chinese tax law added an additional definition to residence beyond the place of incorporation. Under prior law, only domestic companies and FIEs incorporated in China were treated as tax residents. The domestic companies were taxed on their worldwide income, while the resident FIE on only its China source income. With the change in the tax law, foreign enterprises that were managed or controlled from China are deemed resident enterprises and are taxed on their world-wide income similar to domestic corporations.
Observations
Foreign corporations should avoid sending expat employees whose service in China benefits the foreign HQ for periods six months or longer. If there is PE with an establishment in China (RO, WFOE, JV) use an employment contract that stipulates expat employees services is to benefit directly the foreign establishment and only indirectly the HQ.
Do not manage any other foreign subsidiary by expat or locally hired employees resident in China. To mitigate such appearance, make sure time spent by these employees outside China at the other foreign subsidiary locations is well documented. Employees are allowed to split time between foreign locations and China without affecting the tax consequences of their Chinese operations.
Hank Bourg is a U.S. certified public accountant and the head of the North American desk at Dezan Shira & Associates. For comments or inquiries, please contact him at tax@dezshira.com.
