Taxation of China Representative Offices. Part II: US Taxation

I've got bad news, worse news, and great news for you.

The bad news is that the IRS's treatment of activities typically engaged in by ROs becomes incredibly complex depending on the details of the source of RO income, which in turn determines how much of the tax paid by the RO is creditable in the US.

The worse news is that this complexity could, depending on the sophistication of a business's structure, be further increased by the RO being a branch of a foreign subsidiary which purchased the goods from a related US company.  This creates Subpart F issues which could, if the company is willing to pay for it, lead to transfer pricing issues.

The great news is:

1. We are going to distill the bad news into a basic assumption that some of the income created by the RO is U.S. source and some is foreign source; and
2. We are just going to ignore the worse news and assume that the RO is a branch of a US company.

II.  US Taxation of RO Activities

You might be asking yourself, "If ROs are restricted to market research and product promotion, how could there be any taxable income, and why do we care?"  Great questions!

     a.  US Income Tax Overview

We care whether ROs generate taxable income abroad because the US levies an income tax on worldwide income.  If the RO generates China source income, then the US parent company is liable for tax on that income in the US.  However, the amount of tax owed to the US government is reduced by the foreign tax credit.

     b.  How Can ROs Generate Income and What is the Source of that Income?

          1.  Product Promotion ROs

An RO will hopefully generate income for the parent company if its primary purpose is the promotion of the parent company in China.  In my experience working with ROs, an RO typically employs a pseudo-sales team which promotes the goods and services of its US parent company in China.  The sales of goods and/or services contracts are then signed and performed by the US parent.  

If the US parent receives payment for services performed in China, then that income is clearly China source income under the Internal Revenue Code and you can skip right to subsection c. below.  IRC § 862(a)(3).

However, if the US parent is selling goods in China, then the sourcing rules can become very complex depending on a host of factors.  See IRC §§ 861, 862; see Treas. Reg. §§ 1.861-7, 1.863-3.  The basic rule is that income from the sale of goods which the company is in the regular business of selling is sourced at the place where risk of loss is transferred to the buyer.  IRC § 861(a)(6), 862(a)(6), 865(b); Treas. Reg. § 1.861-7.  And if the goods are manufactured in the US and sold abroad, then income from the sale of the goods is partially US source and partially China source.  Treas. Reg. § 1.863-3.

As briefly discussed above, a US company will be subject to tax on all of its income regardless of source, but a company can reduce its US tax bill with foreign tax credits if it is taxed in another country.  This will be discussed below in subsection c.

          2.  Research and Auxiliary ROs
An RO that performs research and/or other auxiliary functions may not be generating any China source income for a US company.  It will, however, unfortunately be taxed under the expense method in China.  In this case, the limitations on the foreign tax credit could prevent the US company from using the EIT and BT paid in China to reduce its US tax bill with the foreign tax credit.

     c.  Foreign Tax Credit
The foreign tax credit gets tricky, and I'll more fully explain it a future, stand-alone post.  For the rest of this post I'll give you straight-ish answers.

If the RO calculated its China EIT and BT based on legal and valid accounting documents, and that EIT and BT is based on income amounts that match the US source rules, and the China taxing authorities accept that calculation, then EIT and BT are likely to be deemed creditable income taxes under the US foreign tax credit regulations.  Treas. Reg. § 1.901-2.  In this case, the general limitation would apply.  The general limitation:

The foreign tax credit must be less than or equal to: Total US Tax Liability * (Taxable Foreign Source Income / Total Worldwide Taxable Income)

If EIT and BT was calculated under the Deemed Profit Method, then EIT and BT paid would not qualify as income taxes but would likely qualify as creditable gross receipts taxes paid in lieu of EIT and BT.  IRC  § 903; Treas. Reg. § 1.903-1.  The general limitation would apply.

If EIT and BT was calculated under the Expenses Method, then EIT and BT paid would not be income taxes and would likely not qualify for the foreign tax credit because these taxes would not be in lieu of an income tax in their entirety for all persons subject to the taxes.  Treas. Reg. § 1.903-1(a).  The reason for this is that while a product promotion company might help generate China source income, a market research company would not generate China source income; and if tax was calculated under the Expenses Method for both, then the tax would not be in lieu of an income tax for both.  See Waterman S.S. Corp. v, U.S., 203 F.Supp. 915 (1962) affirmed 330 F.2d 128 (1964) affirmed 381 U.S. 252 (1965) [holding that US tax authorities should allow a credit for tax if the tax is in the nature of an income tax].   Despite not being able to take a credit, the taxpayer could take an itemized deduction for these taxes.

III.  Conclusion
It is imperative to keep good books to take advantage of the best tax position.  Also, you might want to consider using an entity other than an RO to enter China if you want to minimize your taxes because the Expenses Method or Deemed Profit Method could pump your China tax burden above what the US considers your tax burden if your margins are not as high as the deemed profit rate or if your options are truly only market research.

Taxation of China Representative Offices. Part I: China Taxation

A representative office (RO) is a Chinese business entity that allows a foreign company that has been established for at least two years to engage in the following activities in China:

1. Conduct research;
2. Liaise with China contacts;
3. Promote the parent company;
4. Coordinate the foreign company's China activities; and
5. Make travel arrangements for parent company representatives and Chinese clients.

An RO is not allowed to engage in the following activities:

1. Directly engage in any business for profit;
2. Sign contracts on behalf of the foreign parent;
3. Represent firms other than the foreign parent;
4. Collect money or issue invoices in China; or
5. Buy property or import production equipment.

ROs are also subject to onerous restrictions regarding local hiring.

However, despite all of the drawbacks, it sometimes still makes sense to form an RO in China.  But how are they taxed in China, and what are the US tax implications?  Today, I'll address the China taxation of ROs, and tomorrow I'll write about the U.S. tax implications.

I.  China Taxation of ROs

The most recent China guidance on the taxation of ROs was issued by the State Administration of Taxation on February 20, 2010: Guo Shui Fa [2010] No. 18 ("Circular 18"), Interim Measures on Tax Administration of Representative Offices of Foreign Enterprises.

Circular 18 provides that ROs are required to pay Enterprise Income Tax (EIT) at a 25% tax rate, Business Tax (BT) at a 5% tax rate, and Value-Added Tax (VAT).  Additionally, the RO may be exempt from paying EIT under the US-PRC tax treaty.

     a.  VAT

It is unlikely that an RO will have any VAT liabilities because it should not be in the business of buying and selling goods.  However, if it does have VAT liabilities, then VAT must be declared and paid according to China's VAT regulations.

     b.  EIT and BT

ROs are required to calculate their taxes based on legal and valid accounting documents.  However, if an RO cannot accurately calculate income, costs, or expenses then the Chinese tax authorities may choose to calculate the RO's EIT and BT based on either (1) the expenses method, or (2) the deemed profit method.

Both methods use the deemed profit rate as a variable.  Circular 18 states that the deemed profit rate is no less than 15%, and could possibly be up to 50% depending on the industry.  All examples below use a deemed profit rate of 15%.  Furthermore, all examples use an income tax rate of 25% and a BT Rate of 5%.

          1.  Expenses Method
This method will be used by China's tax authorities if the RO can accurately calculate expenses, but not income.

Calculating EIT and BT based on the expenses method requires the calculation of the deemed turnover or deemed gross revenue of the RO.

Deemed Turnover = Total Operating Expenses / (1 - BT Rate - Deemed Profit Rate)

EIT Payable = Deemed Turnover * Deemed Profit Rate * EIT Rate

BT Payable = Deemed Turnover * BT Rate

Example: Total Operating Expenses = 100 

100 / (1 - 0.05 - 0.15) = 125 Deemed Turnover

125 * 0.15 * 0.25 = 4.69 EIT Payable

125 * 0.05 = 6.25 BT Payable

          2.  Deemed Profit Method
This method will be used by China's tax authorities if the RO can accurately calculate gross revenue, but not costs or expenses.

EIT Payable = Gross Revenue * Deemed Profit Rate * EIT Rate

Example:  Gross Revenue = 100

100 * 0.15 * 0.25 = 3.75 EIT Payable 

      c.  Tax Treaty EIT Exemption
The RO will be exempt from EIT, but not BT or VAT, if it qualifies for exemption under the US-PRC tax treaty, and if the RO files with the appropriate tax authority.

The RO will be exempt from EIT and taxable only in the US under Article 7 of the US-PRC tax treaty if it is NOT a considered a permanent establishment (PE) in China under Article 5 of the tax treaty.  Article 5, paragraph 4 is the relevant paragraph for analyzing whether an RO is a PE, and is reproduced below with provisions that are seemingly related to ROs in italics:

4.  Notwithstanding the provisions of paragraphs 1 through 3, the term "permanent establishment" shall be deemed not to include:

1. the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;
2. the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;
3. the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
4. the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise;
5. 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;
6. 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 business resulting from this combination is of a preparatory or auxiliary character.

Paragraph 4 looks like it was custom crafted to prevent ROs from being treated as PEs and subject to EIT.  However, a familiarity with tax treaties, as well as the Technical Explanation of the treaty, reveals that paragraph 4 is actually the same as in the US Model Tax Treaty.  Accordingly, do not expect the Chinese tax authorities to give ROs a free pass into the non-PE classification, and do be prepared to advocate for that position.

There is one other possible exemption that operates independently of whether the RO is a PE for tax treaty purposes according to Article 7.7 of the tax treaty.  If the RO is promoting the sales of ships or aircraft in China, and the RO can accurately calculate its taxes based on valid and legal accounting documents, then income attributed to the RO from sales by the parent company of such ships or aircraft could be exempted from EIT under Article 12.3 of the tax treaty.

     d.  Conclusion
An RO for a US company may be subject to EIT in China, it will be subject to BT in China, and it will be subject to VAT in China.  Tomorrow, we'll examine the U.S. tax implications of RO taxation in China.

Tax-Free Below-Market Personal Loans from Your Singaporean Mother-in-Law

Scenario
Nonresident alien who is a citizen of Singapore wishes to make $400,000 loan to resident of the United States for the purchase of U.S. real property.

Non-Technical Analysis
With the current tight loan market for those without perfect credit, I have been seeing an increase in personal loans between family members. Even at historically low interest rates, family members often try to help out by offering a below-market or even zero-interest loan. However, this opens up an imputed interest problem wherein the lender's taxable income is calculated by adding the amount of interest the IRS thinks should have been charged to the lender's income.

I've also been seeing an increase in below-market family loans from foreigners to relatives in the U.S. Interest paid on a loan made to a person in the U.S. is U.S. income for the lender, and the lender would typically owe U.S. tax and the borrower would be liable for this tax through an onerous and relatively complicated withholding regime.

However, when the lender is a foreign relative who is not in the business of making loans, there is a good chance that you can avoid imputed income for the lender and avoid onerous withholding requirements. Additionally, if your foreign relative wishes to charge you interest, then there is a good chance that they won't be subject to any tax and you can still take advantage of the home mortgage interest deduction.

Technical Analysis 
Applicable Tax Law 
Singapore and the U.S. do not have an applicable tax treaty. Therefore the appropriate tax law for U.S. income tax purposes is Title 26 of the U.S. Code, hereafter referred to as the I.R.C. Additionally, the California Revenue and Taxation Code applies to all transactions in the exact same way as under the IRC, except as noted.

Analysis in Absence of Any Exemptions 
Mortgage Tax Issues 
It is crucial for you that the loan is a properly registered non-recourse mortgage so that you may take advantage of the home mortgage interest deduction, assuming that this is your principal residence or second home. (I.R.C. 163; Cal. Rev. & Tax. Code, 17201.)

Additionally, the interest rates on the mortgage must be fair market rates. If the interest rates are not fair market rates, then the lender is liable for imputed income based on fair market rates. For example, if the interest rate results in interest paid of $10,000, but a fair market interest rate would have resulted in interest paid of $20,000, then the lender's annual income would be increased by $10,000 for the purpose of calculating income.

Your Mother-in-Law's U.S. Tax Issues and the Consequences for You 
The interest paid to your mother-in-law is U.S. source income for U.S. tax purposes and is subject to a 30% U.S. tax rate. (I.R.C. 871(a)(1)(A).) That means that your mother must pay 30% U.S. tax on her interest income.

Furthermore, as the payor on the mortgage you are responsible for withholding, reporting, and paying the 30% tax on the interest payments to your mother-in-law. (I.R.C. 1441.) You are required to withhold 30% of the interest payment at the time of payment, submit this payment to the IRS, and report this information to the IRS on form 1042-S and 1042. You are required to deposit with the IRS electronically, and the frequency with which you deposit the withheld taxes is determined by how much tax tax you have withheld. (See Treas. Regs. 1.1461-1(a), 1.6302-2(a).)

For example, if $1,000 of your monthly mortgage payment was for interest, then you are required to withhold 30% or $300. (I.R.C. 871(a), 1441.) Since that number is greater than $200 and less than $2,000, then you are required to electronically deposit $300 by the 15th day of the next month after the tax was withheld.

Analysis with Exemptions 
If the loan is interest-free and your mother-in-law is not in the regular business of making loans, then there is actually a specific regulation that exempts your mother from imputed income for a below market loan. (Treas. Reg., 1.7872-5T(b)(10), (c)(2).) This means that you can receive a below market loan from your mother-in-law and not subject her to any tax.

Additionally, if your mother-in-law wishes to charge you interest and you want to take advantage of the home mortgage interest deduction, then you do not need to do any withholding on the interest payments so long as several technical requirements are met which result in the interest being qualified as "portfolio interest."  (IRC 871(h); Treas. Reg. 1.871-14.) One of the requirements is that the mortgage must be registered. Another requires you to file a W-8 form with the IRS declaring that your mother-in-law is not a US person. If it's not registered, then the portfolio interest exception does not apply, and the withholding requirements do apply. You would, however, still need to file withholding documents with the IRS. Although this sounds complicated, it's not in practice. You just need to let your tax preparer know all of the facts, and make sure that they file all of the proper tax forms.

And you could combine the lack of imputed income with the portfolio interest deduction to receive a below market loan, and deduct the interest payments actually made.