In doing business in China, one of the key aspects to be aware of is the issue of whether or not your home country has a double taxation agreement (DTA) with the mainland. While about 75% of the actual text in any DTA is identical with the text in any other DTA, the applicability and specific provisions of each treaty can vary considerably.
This is why it is a good idea to check out the bilateral provisions your country may enjoy with the PRC. A DTA can make it possible for you to engage in business there without needing to pay tax – even though you have a permanent office and employ people in China.
The key is to carefully structure your activities and to act within the bounds of the DTA. The important concepts to consider are those of Residency, Permanent Establishment and Business Profits, and how the applicable double taxation agreement treats these issues.
Firstly though, let’s examine the countries that currently have a DTA with China. The impressive list is shown below:
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Does your country have a DTA with China?
It should be noted that Hong Kong, a special administrative region of China, has also concluded tax treaties with other countries apart from Mainland China, almost all concentrating on the banking, logistics and aviation industries, as follows:
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Countries that have a DTA with Hong Kong
Hong Kong adopts the territoriality basis of taxation, whereby only income/profit sourced in Hong Kong is subject to tax. Therefore, Hong Kong residents generally do not suffer from double taxation.
Many countries that tax their residents on a worldwide basis also provide their residents operating businesses in Hong Kong with unilateral tax credit relief for any Hong Kong tax paid on income/profit derived from Hong Kong. Hong Kong allows a deduction for foreign tax paid on turnover basis in respect of an income which is also subject to tax in Hong Kong.
Businesses operating in Hong Kong therefore do not generally have problems with the double taxation of income.
Hong Kong’s relationship with Mainland China under the terms of the Hong Kong-China DTA provides tax relief, for example, on payment of dividends, which is usually subject to 10% remittance tax in China – this can be reduced to 5% if the recipient company is based in Hong Kong.
Understanding DTAs: Residency
The China-Luxembourg DTA
is a good example of a typical double taxation agreement. Tax treaties as documents are of a bilateral nature. While DTA signing countries are not all members of the Organization for Economic Cooperation and Development (OECD), DTAs are mainly based upon the model conventions developed by this body.
As noted above, the three important concepts in understanding DTAs in connection with China are residency (Article Four in the China-Luxembourg DTA), permanent establishment (Article Five) and business Profits (Article Seven).
The Residency article in DTAs provides ‘tie-breaker’ rules for determining, for the purposes of the agreement, where an individual is resident under the respective domestic laws of the two countries. These rules consist of a series of tests to be applied successively, until residence for the purposes of the agreement is allocated to one State or the other.
Once a test is conclusive, it is unnecessary to apply subsequent tests. As with all double taxation matters, it is essential to look at the text of the particular agreement in point.
Generally the tests appear in the following order:
- Permanent home: An individual is a resident of the State in which they have a permanent home available to them (though not necessarily owned by them). If they have a permanent home available to them in both States, it is necessary to look at the next test.
- Centre of vital interests: An individual is a resident of the State to which their ‘personal and economic relations’ (a wide expression intended to cover the full range of social, domestic, financial, political and cultural links and relationships) are closer. If it is not possible to determine this, or if they have no permanent home available in either State, then it is necessary to look at the next test.
- Habitual abode: An individual is a resident of the State in which they have their habitual abode. If they have a habitual abode in both States or in neither, then it is necessary to look at the final test.
- Nationality: An individual is a resident of the State of which they are a national.
Understanding this article is key when establishing whether or not your company is hiring personnel whose residency can be construed as being in China. If so, this can trigger permanent establishment (PE) status and exposure to income tax in China (even if your corporation is physically based outside of the country).
Understanding DTAs: Permanent establishment
The treaty article concerning permanent establishment is of the utmost importance when considering the tax implications of your business relationship with China. It is perhaps the most important application of a DTA relating to companies trading with China.
Virtually all double taxation treaties cut down a country’s right to tax profits of a foreign company or enterprise by providing that the profits derived in one country will not be subject to tax in the other country, unless the business is carried on through a permanent establishment.
Additionally, where business is carried on in the other contracting country through a permanent establishment, only business profits actually attributable to that establishment may be taxed. This prevents the mere presence of a permanent establishment from giving rise to tax liabilities on unrelated income.
A vital concern in this case is what is meant by ‘permanent establishment’ for the purposes of the treaty. This is normally defined in some detail in one of the articles of the treaty.
The primary definition of a permanent establishment is typically a ‘fixed place of business through which the business of an enterprise is wholly or partly carried on.’ The definition will then normally go on specifically to include:
- a place of management
- a branch
- an office
- a factory
- a workshop
- a mine, oil or gas well, quarry or other place of extraction of natural resources
Other activities specifically deemed to represent a permanent establishment are a building or construction site, or an installation project existing for more than 12 months, and a person who has and habitually exercises authority to conclude contracts on behalf of the enterprise.
More importantly for a company seeking to avoid taxation in a foreign country, the definition of a permanent establishment usually excludes certain activities even if conducted through a fixed place of business. These often include facilities used by the enterprise solely for:
- storage, display or delivery of goods
- maintenance of stocks for storage, display, delivery or for processing by another enterprise
- purchasing an office
A combination of the activities will similarly be excluded provided the overall activity is of a preparatory or auxiliary character. Another exclusion from the definition of a permanent establishment is a broker, general commission agent, or other independent agent acting in the ordinary course of their business. However, reference to the particular treaty in question should be taken.
Understanding DTAs: Business profits
Many tax systems provide for collection of tax from non-residents by requiring payers of certain types of income to withhold tax from the payment and to remit it to the government.
This includes China, which has a fairly complex system of withholding tax rates depending on the type of service. Such income often includes interest, dividends, royalties, and payments for technical assistance.
Most tax treaties reduce or eliminate the amount of tax required to be withheld with respect to residents of a treaty country, and this includes those with China. In this manner, business profits can be increased by invoking the relevant treaty clause and reducing the amount of withholding tax payable in China. This can have a significant impact on the total tax burden.
This is true, for example, in the UK-China DTA, amended in 2011. The changes mean that withholding tax on repatriated dividends are cut in half from 10% to 5% in shareholdings of 25% or higher in a Chinese company (a definition that includes foreign- invested commercial enterprises, wholly foreign-owned enterprises and joint ventures).
As profits in China are now significant for many multinational corporations, such treaty applications can mean potential savings of millions of renminbi in profit that would otherwise be payable in tax.
Eliminating import duties
In addition to DTAs, free trade agreements (FTAs) between China and your country can also minimize or eliminate entirely payment of import duties on your products.
China has a free trade agreement (FTA) with ASEAN, which reduced to zero the tariffs on nearly 8,000 products, representing 90% of imported goods, in China and six ASEAN nations – Brunei, Indonesia, Malaysia, Philippines, Singapore and Thailand. China’s neighboring ASEAN state, Vietnam, along with Cambodia, Laos and Myanmar will follow suit in 2015.
China’s FTA with ASEAN also means that the cheaper labor rates in some markets in ASEAN can justify the basing of production facilities in countries such as Vietnam to be used as a supply base for the China market. This is highly pertinent given that China’s labor costs are significantly increasing.
The ASEAN-China FTA is having the effect of pushing labor intensive manufacturing to ASEAN nations, while at the same time avoiding any duty penalty in doing so.
China is now in negotiations with Australia, India, Japan and New Zealand (together with ASEAN) over forming a free trade area known as the Regional Comprehensive Economic Partnership (RCEP). This agreement is still being brokered, though it was endorsed by ASEAN eight months ago.
When enacted, RCEP will reduce or eliminate import duties into China once again on thousands of products from each of these countries. As a result, intra-Asian trade flows are expected to double by 2020 and underpin what will be the world’s fastest growing trade and economic bloc – Asia, including China and India.
More opportunities to reduce taxes and tariffs in China are on the cards. Beijing is currently going through a process of upgrading many of its DTAs. Both the Netherlands and Qatar recently expanded their treaties with China and Hong Kong.
Switzerland has also signed a memorandum of understanding concerning a complete FTA with China – the first country in the European Union to do so. If ratified, the FTA will reduce tariffs to zero on 84.2% imports from Switzerland. In return, Switzerland will offer zero tariffs for 99.7 percent of China’s exports.
While businesses may not completely do away with the necessity of paying tax in China, it can certainly be minimized. Double taxation treaties create the opportunity for companies to trade abroad without incurring foreign taxation. What is needed is to carefully structure their activities in China such that they do not represent a permanent establishment in accordance with the terms of the applicable DTA.
Under certain conditions, DTAs can also allow business to be conducted with China, including that of permanent trade, without the need to pay tax, yet armed with the benefits of both on-the-ground personnel and an office.
Many companies whose home nations are signatories to DTAs that China has in place are not always aware of the benefits they can bring. They are also non-specific – meaning DTAs apply to small and medium-sized enterprises as well as multinational corporations.
It is time to evaluate your DTA with China, be aware of its contents, and to utilize it in a way in which they were intended – to boost trade with China by reducing or eliminating tax.
About the Author
Chris Devonshire-Ellis is the founding partner and principal of Dezan Shira & Associates, a specialist foreign direct investment practice that provides advisory services to multinationals investing in emerging Asia. This article was first published in China Briefing and was reedited for clarity and conciseness. For further details or to contact the firm, please visit www.dezshira.com.
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